The Epicurean Dealmaker

All Together Now

noreply@blogger.com (The Epicurean Dealmaker) — Sun, 22 Jan 2012 22:33:00 +0000

“Do you mean, sir, that these birds are cannibals?”

“That’s an odd question, young Master,” the banker said. “I merely said the birds drink blood. It doen’t have to be the blood of their own kind, does it?”

“It was not an odd question,” Paul said, and Jessica noted the brittle riposte quality of her training exposed in his voice. “Most educated people know that the worst potential competition for any young organism can come from its own kind.” He deliberately forked a bite of food from his companion’s plate, ate it. “They are eating from the same bowl. They have the same basic requirements.”

— Frank Herbert, Dune

Steve Randy Waldman got me thinking today.¹

In an extensive follow-up piece to a previous post on complexity in finance, Steve answers objections to and elaborates on his argument that not only is opacity integral to the financial system of a complex society, it is essential. You may recall the core of his original idea:

Finance has always been complex. More precisely it has always been opaque, and complexity is a means of rationalizing opacity in societies that pretend to transparency. Opacity is absolutely essential to modern finance. It is a feature not a bug until we radically change the way we mobilize economic risk-bearing. The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear.

Financial systems help us overcome a collective action problem. In a world of investment projects whose costs and risks are perfectly transparent, most individuals would be frightened. Real enterprise is very risky. Further, the probability of success of any one project depends upon the degree to which other projects are simultaneously underway. A budding industrialist in an agrarian society who tries to build a car factory will fail. Her peers will be unable to supply the inputs required to make the thing work. If by some miracle she gets the factory up and running, her customer-base of low capital, low productivity farm workers will be unable to afford the end product. Successful real investment does not occur via isolated projects, but in waves, forward thrusts by cohorts of optimists, most of whom crash and burn, some of whom do great things for the world and make their investors wealthy. But the winners depend upon the existence of the losers: In a world where there was no Qwest overbuilding fiber, there would have been no Amazon losing a nickel on every sale and making it up on volume. Even in the context of an astonishing tech boom, Amazon was a pretty iffy investment in 1997. It would have been an absurd investment without the growth and momentum generated by thousands of peers, some of whom fared well but most of whom did not.

I think Steve’s analysis and critique are essentially correct. However, I am much less sanguine than he seems to be when it comes to eliminating much of the opacity and associated “kleptocracy” he finds in our current financial system. My pessimism is based on two rather sizeable barriers: human history, and human nature.

* * *

Human beings, we are told, evolved as social animals. From the very first dawn on the ancient savannah, our ancestors must have struggled with the solution to problems of collective action: how to provide security, shelter, food, and comfort to the members of the group or tribe. Given the natural variability among members of any population—whether along simple biological dimensions of age, infirmity, and strength, or more abstract qualities like ambition, skill, and desire—humans must have come to adopt and practice the division of labor early and often. Some would stay behind to protect the encampment, make and mend clothing, and build and maintain shelter while others foraged or hunted for food. Each member of the tribe would cede some of his or her personal agency to other individuals or groups in exchange for reciprocal aid. In this way, the group became stronger than any one of its members. In this way, through trial-and-error invention of division of labor according to comparative advantage, human groupings created social surplus, and complex societies were born.

Over the course of human history, we have developed numerous systems and institutions to address recurring problems of collective action. We developed standing governments to organize and direct our individual efforts toward persistent common goals, like safety, security, and other large challenges. We developed politics as a means for people to make collective decisions about authority and power in government and elsewhere. We built economies as a means to organize collective and individual economic action toward sustained or increasing prosperity. We developed judicial systems to adjudicate inevitable disputes and promote the cause of justice. Each and every one of these systems requires the individual citizen to surrender a portion of his will and agency to the collective. And each and every one of these entities creates, thrives on, and indeed cannot function without opacity.

Think about it: Do you know how and why decisions are made and actions are taken inside government bureaucracies? Do you know what takes place in smoke filled rooms among politicians and lobbyists, whose horses are traded and for what? Do you trust politicians to have your best interests or even the interests of the people who elect them at heart? Do you trust big business of any sort—insurance companies, oil companies, auto manufacturers, pick an industry—not to cut corners when it increases shareholder returns or executive pay? For that matter, do you trust your local auto repair shop to install the brand new muffler it charges you for, and not a refurbished one? Do you really believe our judicial system promotes justice? Do you trust lawyers?

Each of these social institutions creates opacity through the simple mechanism of dividing people into insiders and outsiders. The insiders have the advantage of knowing how things really work, how to “work the system,” and how to profit—economically, socially, and/or politically—from it. Information asymmetry (the source of opacity) is built into the very fabric of the division of labor in complex societies. Furthermore, creating specialized entities to handle collective tasks each of us individually neither can nor wants to address creates institutions whose primary aims become self-preservation and continued aggregation of power. Just like in finance, insiders’ privileged position and knowledge enable them to extract rents. It’s just that rents accruing to insiders in areas other than finance can take the form of social prestige, political power, and legal authority, in addition to undeserved money.

* * *

None of this should be particularly surprising to anyone who takes the time to reflect on it. Why do we tolerate opacity in our collective social institutions and rent-seeking (if not outright corruption) in the people who work there? Because, I must believe, after thousands of years of experimenting, we have not come up with any better way. No-one except a criminal really likes a rent-seeker, and no-one but a politician’s spouse likes a corrupt politician, but collectively we have come to accept the occasional example as the price we must pay in order to outsource the prosecution of certain of our interests to other people. It is a convenience tax. And just like any tax, we whine and complain about it, but we pay. “You can’t trust bankers/lawyers/politicians/bureaucrats/pick-an-actor.” Only when the basic services they provide collapse, or the excess rents they extract become too egregious, do we take up our pitchfork and torch to revisit the social contract.

The problem of opacity and rent-seeking by the insiders of the social institutions we empower to promote our collective good is less bad than it might be—and, therefore, more durable as a feature of complex society—for a number of reasons. For one thing, most people in such privileged positions of power really are not crooked cheats simply out for themselves. Most government bureaucrats, politicians, businesspeople, lawyers, and bankers really do believe they are providing a useful and perhaps even noble service. They view their privileges and socioeconomic rents not as perks unjustifiably pilfered, but as concrete confirmation of the worth and value which society—the people, the voters, the market, etc.—places upon their efforts. They think they deserve them.² Given that society allows or even encourages such actors to enjoy such special privileges, it is hard to argue that they are wrong.

For another, the tax which insiders extract for these services is, in the main, relatively small compared to the good their actions provide to the collective. Steve Waldman himself admits that:

Over the broad scope of history, societies with financial systems that mobilize capital opaquely and at very large scale have completely dominated those that have relied only upon consenting risk assumption by well-informed individuals. Industrialization occurs in societies with corrupt and fragile big banks, or else in societies where the state coerces and obscures risk-bearing and reward-shifting on a large-scale, or (more usually) both. China is a great present day example. That does not mean it would be impossible to develop a set of institutions that would be both effective and transparent. But it does mean developing such a system is an ambitious and ahistorical project, not a mere matter of “fixing what’s broken”. Under present arrangements, transparency and what we perceive as effectiveness stand in opposition to one another. It is incoherent to demand transparency and expect “more” macroeconomically stimulative intermediation from our current financial system.

Starkly put, what is a few billion dollars of excess compensation, here and there, if it enables the growth and prosperity of trillions of dollars of global economic activity?³

* * *

Finance is a critical function in today’s complex global economy. It is clear it stumbled badly in performing its basic function, and it seems beyond argument that it has far outgrown its proper place in the socioeconomic sphere and its share, deserved and undeserved, of the economic pie. But I find it hard to imagine any meaningful function performed by the financial system which can be purified into a transparent, corruption-free zone. Among government, politics, economy, and law, modern finance is a relative newcomer in the panoply of social institutions designed to promote the collective good. Given that no-one has demonstrated the ability to make any one of those older systems meaningfully transparent and corruption-free, I remain highly skeptical that we can do so with finance.

Yes, Steve, I admit the baby in the bathwater is fat, obnoxious, and ugly.⁴ But it is our baby. Do you still want to throw it out?

¹ Yes, believe it or not, it does happen on occasion. Steve is particularly good at triggering it, because he normally has such interesting things to say.
² Hence, e.g., the outraged sensibilities of financiers when you ask them to justify their relatively stratospheric pay: “But that’s what the market bears!” In other words, “I’m worth it!”
³ Especially if, as recent data seem to suggest, intragenerational wealth accumulation is more volatile and intergenerational wealth accumulation is less certain than it used to be. Personally, I am far less bothered by the rise and fall in one or two generations of self-made (finance) billionaires than I would be by the reestablishment of multigenerational dynastic wealth and all the sclerotic, corrupt sociopolitical accompaniments that would bring.
⁴ Steve also objects that our current financial system is incompetent when it comes to allocating systematic risk. He uses the examples of misallocating capital to faddish investments and the sticking of the unemployed and the indebted taxpayer with the biggest portion of the bill due from the collapse of the housing sector. But this misinterprets the proper role of the finance sector. The proper role is as servant to investors and users of capital. Investment bankers don’t sit in a back room, picking winners and losers like Chinese government ministers; we respond to capital supply and demand. Sure, such a system is widely acknowledged to be wasteful and subject to bubbles and fads, but it also has a long-term record of success I would stack up against any centrally planned economy’s any day. Given a choice between the (fallible) wisdom of crowds and the whim of a rent-collecting government technocrat insulated from market forces, I’ll take the crowds any day. Also, given that finance serves the broader society, why should we be surprised when it responds to the dictates of power by sticking failures to the little guy? That’s just politics.

© 2012 The Epicurean Dealmaker. All rights reserved.

A Certain Moral Flexibility

noreply@blogger.com (The Epicurean Dealmaker) — Sat, 21 Jan 2012 22:56:00 +0000

Marty: “When I left, I joined the Army, and when I took the service exam, my psych profile fit a certain... ‘moral flexibility’ would be the only way to describe it. I was loaned out to a CIA-sponsored program, and we sort of found each other. That’s the way it works.”
Debi: “So you... you’re a government spook?”
Marty: “Yes. I mean no. I was before, but I’m not now. Uh, but that’s all irrelevant, really. The idea of governments, nations is public relations theory at this point.”
Debi: “I don’t want to hear about the theories. I want to hear about the dead people. Explain the dead people. Who do you kill?”
Marty: “That’s very complicated, but I think in the beginning it matters of course that you have something to hang on to, you know, a specific ideology to defend, right? I mean, taming unchecked aggression, that was my personal favorite. Other guys liked live free or die, but you know... you get the idea. But that’s all bullshit. And I know that now. That’s all bullshit. You do it because you’re trained to do it, you’re encouraged to do it, and ultimately, you know, you... get to like it. I know that sounds... bad.”
Debi: “You’re a psychopath.”
Marty: “No no no. A psychopath kills for no reason. I kill for money. It’s a job. That didn’t sound right.”

— Grosse Pointe Blank

Your Dedicated Bloggist and Dilettantish Cineaste finally got around to watching Margin Call in the private screening room of the Volcano Lair yestereve, O Dearest of All Readers. Because I am feeling unaccountably magnanimous this evening, I thought I would share with you a brief report of my reactions to the film and a few thoughts which it inspired, out of the goodness of my heart. While you must not expect great film criticism, I believe I can offer a little professional insight which may enhance your experience should you decide to view it.

For let me first say that I recommend the movie unreservedly, not only to professionals within the investment banking industry but also to outsiders still in possession of their moral compass. The lighting, cinematography, casting, and dialogue is, for the most part, pitch perfect, and the movie conveys exceptionally well the mood and atmosphere of the sales and trading end of a big investment bank. The story is simple enough: a junior risk manager played by Zachary Quinto takes over a risk model from his recently fired boss and mentor; he discovers his bank has already begun to seriously violate risk limits in the structured trading book it maintains to warehouse mortgage-backed securities it structures and sells for enormous profit; he concludes the firm faces potential losses which could wipe it out entirely; and he runs his warning up the chain of command, where it ultimately lands in the lap of the firm’s CEO. Where and with whom, as the saying goes, the shit decisively hits the fan.

The film takes place over approximately 36 hours, starting from mass firings at the bank during one trading day, Quinto’s fateful discovery that evening, the hurried, all-hands meetings and consultations among firm management overnight, the liquidation of the firm’s toxic portfolio the following day, and a coda the following night. It is an ensemble performance, and Quinto, Penn Badgley, Paul Bettany, Stanley Tucci, Kevin Spacey, Demi Moore, Simon Baker, and Jeremy Irons all do excellent work. Just like real life, there are no heros, and just like real life the characters spend little time reflecting or moralizing about how they got into this mess. They decide, they act, and just like most corporate bureaucrats they limit their moralizing to variations on “I told you so” and “It’s your fault, not mine.”¹

The moral center of the film is carried by Kevin Spacey, who plays the slightly sallow, squidgy Head of Sales and Trading, a 40-year veteran of the firm with the scars to prove it and a personal life in tatters. He is the only one who stands up to Irons’ CEO when the latter decides to liquidate the firm’s entire portfolio of MBS securities. Tellingly, however, his objection is that dumping these toxic securities on unwitting buyers in a fire sale will destroy both his and his salespeoples’ reputations and careers, not that selling securities you know are about to implode to clueless counterparties is wrong per se. Also tellingly, the film is honest enough to show Irons overcoming Spacey’s scruples with a big, fat check, and Spacey accepting it because he “needs the money.” No-one is innocent here, except perhaps those too junior and ignorant to have done more than act as cogs in the immense corporate machine. The callow immaturity of Penn Badgley’s 23-year-old, who gossips about the rumored wealth of his superiors while his firm teeters on the brink of annihilation, is the film’s answer to those who might think that innocence begot by ignorance is some sort of virtue.

Like anyone who works inside the temple, I do have some minor quibbles with the way the film portrays my industry, but they are of little consequence.² The investment bank is able to extricate itself, at some considerable cost, it seems, from its predicament over the course of one trading day. This keeps the story clear—save yourself and your firm at the cost of your counterparties and your reputation—but correspondingly unrealistic and oversimplistic. Any bank which really faced such circumstances would find its distress telegraphed within minutes of commencing its liquidation, with the consequent disappearance of buyers, massive selling by everyone else in the market, and determined financial attacks on its funding and asset base by hedge funds and lenders alike. No bank could withstand the kind of massive markdowns of its inventory, sold or not, which the movie portrays without calling its very existence into question. Margin Call is not a realistic depiction of what happened to Bear Stearns or Lehman Brothers.

Nor does the movie attempt to explain the financial crisis, or any large component of it. It depicts nothing outside the walls of the firm or actions of its characters. It is a miniature, which drops the viewer in medias res, to look at the behavior of high-powered, well-paid professionals under considerable pressure. It is a study in how bureaucratic organizations respond to life or death threats, and what people who have little choice do to survive. Like most survival stories, it is not a pretty sight.

Perhaps the people in my industry are more callous and calculating than others. It is certain we are more willing than some to sacrifice our own in the name of survival. But I will leave it to you, Dear Reader, to decide whether Margin Call is simply an indictment of investment banking, or an indictment of humanity itself.

¹ Nor are there any cardboard cutout villains, unless you consider naked ambition, backstabbing, scapegoating, buck-passing, and covering your ass villainy. I, on the other hand, consider those standard corporate policy at any organization larger than twenty people.
² No CEO of a major investment bank would wear his hair as long as Jeremy Irons, for example. Period.

© 2012 The Epicurean Dealmaker. All rights reserved.

All’s Fair...

noreply@blogger.com (The Epicurean Dealmaker) — Sun, 15 Jan 2012 20:45:00 +0000

“Musashi!”

No answer.

“Musashi!”

The sea rumbled ominously in the distance; the tide lapped and murmured at the two men’s feet.

“You’re late again, aren’t you? Is that your strategy? As far as I’m concerned, it’s a cowardly ploy. It’s two hours past the appointed time. I was here at eight, just as I promised. I’ve been waiting.”

Musashi did not reply.

“You did this at Ichijōji, and before that at the Rengeōin. Your method seems to be to throw your opponent off by deliberately making him wait. That trick will get you nowhere with Ganryū. Now prepare your spirit and come forward bravely, so future generations won’t laugh at you. Come ahead and fight, Musashi!” The end of his scabbard rose high behind him as he drew the great Drying Pole. With his left hand, he slid the scabbard off and threw it in the water.

Waiting just long enough for a wave to strike the reef and retreat, Musashi suddenly said in a quiet voice, “You’ve lost, Kojirō.”

“What?” Ganryū was shaken to the core.

“The fight’s been fought. I say you’ve been defeated.”

“What are you talking about?”

“If you were going to win, you wouldn’t throw your scabbard away. You’ve cast away your future, your life.”

“Words! Nonsense!”

“Too bad, Kojirō. Ready to fall? Do you want to get it over with fast?”

“Come... come forward, you bastard!”

“H-o-o-o!” Musashi’s cry and the sound of the water rose to a crescendo together.

— Eiji Yoshikawa, Musashi¹

* * *

Ex-banker and would-be gadfly to the investment banking industry William Cohan posted a very silly opinion piece over at The Washington Post last Friday. In it, he cites his experience as an M&A advisor helping clients sell their companies to explain that he found private equity firm Bain Capital particularly prone to using “bait and switch” negotiating tactics. Mr. Cohan explains:

In my experience, Bain Capital did all that it could to game the system by consistently offering the highest prices during the early rounds of bidding — only to try to low-ball the price after it had weeded out competitors.

Once it had passed through the intermediate competitive bidding rounds and earned exclusive negotiating rights with the company, Bain’s due diligence professionals

would suddenly begin finding all sorts of warts, bruises and faults with the company being sold. Soon enough, that near-final Bain bid — the one that got the firm into its exclusive negotiating position — would begin to fall, often significantly.

Now, I cannot say whether Bain Capital was (or still is) particularly prone to using bait and switch tactics in sell-side auctions. I can say, pace Mr. Cohan’s few counterexamples, that they are definitely not alone in doing so, nor is any private equity firm averse to using such tactics when they calculate it is to their net advantage. Mr. Cohan’s description of the bidding process in a sell-side auction is highly simplified, but basically accurate. Where he goes seriously off the rails, however, is in trying to cast doubt on Mitt Romney’s character and appropriateness for public office based on his own highly anecdotal experience with Bain Capital:

This win-at-any-cost approach makes me wonder how a President Romney would negotiate with Congress, or with China, or with anyone else — and what a promise, pledge or endorsement from him would actually mean.

Would a President Romney, along with a Republican Congress, cut taxes for the wealthy even more than he has pledged to do? Would he not try to balance the federal budget, even though he has said he would? Would he protect defense spending, as he has indicated he would?

I have no idea how Romney might behave in office. I do believe, however, that when he was running Bain Capital, his word was not his bond.

This reeks of a staggeringly naive and simplistic view of finance and politics. Does Mr. Cohan expect us to disqualify Mr. Romney from office because he ran a firm which fielded clever, tenacious negotiators who fought their corner hard? Does he really believe that sharp-elbowed negotiating tactics are unknown and/or frowned upon in the halls of Congress or the state ministries in Beijing? Does he think the American people want a morally squeamish milquetoast conceding their interests at home and abroad because he doesn’t want to get his hands dirty? Does he believe there is anyone in this country under the age of 18 who truly thinks that politicians either do or should honor their promises no matter the consequences or whose interests they injure? Citizens of a complex society expect and demand their elected officials to combine firm principles, moral and ethical flexibility, and tactically astute pragmatism to achieve the goals they have been elected for. That’s why it’s called politics. Anyone who thinks otherwise is a bloody fool.

And attempting to tar Mr. Romney with the brush of his junior partners’ supposedly naughty behavior decades ago—even though Mr. Cohan admits that he never dealt with Romney directly—is transparently tendentious and disingenuous. This does not jibe with Mr. Cohan’s own stated principles of honor and character.

For, speaking as a banker who dislikes private equity firms (and other potential buyers) who bait and switch processes just as much as Mr. Cohan does, let me make this perfectly clear: by doing so, Bain Capital did nothing wrong.

* * *

Selling companies or divisions of companies is one of the cleanest, least-conflicted, and most valuable services investment banks provide.² It is also one of the most varied and complex processes we conduct. While the end result of most sale processes is the same—money passes from the hands of one party in exchange for the ownership stake of another—the actual sale process for every property is for all intents and purposes unique. The overall structure of a typical sales process is fairly straightforward:

Seller hires sell-side advisor
Advisor works with seller to select sale strategy, identify potential buyers, compile information on business, conduct due diligence, and create marketing materials
Advisor contacts potential buyers for interest in property, signs confidentiality and standstill agreements, and gives buyers preliminary information
Buyers submit initial bids (“indications of interest”) with summary preliminary offer terms
Seller and advisor select buyers to pass into next round
Seller management present further information to selected buyers and buyers begin documentary, legal, and business due diligence
Buyers submit formal offer letters
Seller and advisor pick one or more buyers for further negotiation (which may involved extending exclusive negotiating privileges to one buyer)
Buyer(s) conduct confirmatory due diligence and negotiate legal purchase agreement and other deal documents
Buyer and seller agree final terms
Transaction closes

Although it is not always true, most sale processes nowadays are what Mr. Cohan calls “auctions,” in which the advisor approaches a very broad range of potential buyers, usually both private equity firms and corporate (or “strategic”) buyers. There are two purposes for that: 1) broad participation tends to ensure the highest level of competition among buyers, which tends to produce the highest price and best terms for the seller; and 2) auctions are good for properties which may be unique, poorly understood by the market, and/or for which the “best” buyers are unknown. In the latter case, the broad-based, shotgun approach to the market tends to flush out hidden or unexpected high bidders much more efficiently.

Now, as you might expect from sophisticated financial buyers who have a fiduciary duty to maximize returns on invested funds to their limited partners (and who have their own financial interests in mind, too), private equity firms hate auctions. They much prefer to find a fat, unsophisticated seller without professional representation whom they can wheedle and cajole into negotiating exclusively on terms advantageous to the buyer. Fortunately for Yours Truly and my fellow financial ~~parasites~~ intermediaries, most companies nowadays have heard enough about mergers and acquisitions to realize they are much better served getting professional help, and we professional help are more than happy to persuade them they will get a much better price for their baby by selling it at auction.

As a bidder in an auction, of course, your best strategy is to bid high enough to get into the next round. Unlike my skeleton outline above, though, there can be multiple bidding rounds in a company sale process, so bidders have little incentive to lowball their bids unless they are truly indifferent to winning. On the other hand, the deeper you get into a sale process, the more time, opportunity cost, and direct due diligence expenses (e.g., accountants, lawyers, consultants, etc.) each bidder expends, so buyers will tend to drop out rather than bid on companies they don’t think they can win. The sell-side advisor’s job is to maintain as much competitive tension as possible among the bidders for as long as possible. Ideally, the advisor can run a process where the seller has multiple bidders competing to the very last moment without exclusivity. Such processes are a banker’s dream, for the prices and terms realized for the seller make us look like heros. Plus, it’s a blast to beat up private equity professionals and their lawyers all in the name of client service.

But sooner or later, the usual sale process gets to the stage where the seller grants the buyer exclusive rights to negotiate a final deal. At that point, the negotiating leverage which the seller has enjoyed drops dramatically, and the buyer has every opportunity and incentive to begin whittling away at the price it promised, using new facts discovered in due diligence, weakening industry fundamentals, unfavorable market conditions, or even sunspot activity as an excuse. This is where the sell-side advisor earns his or her fee. He must argue the facts (“No, the complete economic collapse of the Eurozone will have no effect whatsoever on the sales volumes of Acme European Imports, Inc.”), emotions (“My client is beginning to think you’re a real dick.”), tactics (“We have three other buyers chomping at the bit in the wings, and their offers were all higher than the new lower offer you are proposing.”), and anything else he can to weaken the buyer’s attack. Because, you know, at the end of the day the entire process is a negotiation.

Furthermore, private equity firms (and corporate buyers, too) do not have a completely free hand to work bait and switch tactics. The most important restraint is reputation, which Mr. Cohan himself mentioned and demonstrated in his article. Firms which commonly bid high then almost always claw back value during exclusivity periods get widely known for doing that among bankers. The Street can be a very small place. Repeat offenders get put in the penalty box, don’t get shown deals (like Mr. Cohan did), get used as stalking horses to boost the offer prices of preferred bidders, and generally get fucked with by bankers who find them annoying. It is important not to overstate the restraint which reputation imposes on private equity firms, however, because they also tend to be the biggest fee payers in the M&A market, and investment banks (especially those with big leveraged finance operations which private equity uses to fund their purchases) are careful not to shut them out or fuck them over completely. Another restraint is the relationship which private equity buyers need to build with the management of the firm they are buying. Most private equity firms do not want to replace incumbent management—at least right away—after buying a company, so they need to maintain friendly, productive relations with them. If the management is the owner/seller, baiting and switching can really poison a potential future working relationship, if not scupper it completely.

* * *

Bain Capital may indeed have been more inclined to retrade offers during exclusivity periods than many of its competitors, but this may have been due to the legacy and practices inculcated in its ranks by the eponymous consulting firm which spawned it. Bain is notorious for approaching private equity investing with armies of (ex-Bain) consultants, who pore over the books, records, and operations of subject companies looking for areas to improve, like consultants do. Bain may simply have found more flaws and blemishes in their potential purchases than other, less manpower-intensive PE buyers. If they learned to expect that outcome, they may have settled on a strategy to bid higher than others in early rounds because they wanted a chance to win a few deals.

At the end of the day, however, it is important to keep in mind that selling a company is always and everywhere a negotiation: There is no “true,” “honorable,” or “correct” value for a business.³ The tactics, process, and outcome all depend upon the relative negotiating leverage of the parties involved, and it should be no surprise to anyone that the stronger party will win out most of the time. A clever and resourceful sell-side advisor can try to maximize the leverage of a seller with a weak hand, but at the end of the day even genius rainmakers can’t make it rain in the Sahara in ~~August~~ June.⁴ What is not at stake, however, is an archaic view of “honor and character” that requires a bidder to pay more than it ought to (or, what is the same thing, what it can get away with) simply because some prissy investment banker can’t bring himself to get down in the mud and wrestle for his client.

That’s what they pay us the big bucks for, Bill, not for swanning about in Saville Row suits at The Four Seasons. You should remember that.

More on dirty hands, politics, and negotiation:
In the Nation’s Service (December 29, 2011)
You Realithe, Of Courth, Thith Meanth War (May 3, 2009)
More of a Kickin’ Sitcheyation (May 11, 2009)

¹ Eiji Yoshikawa, Musashi. Tokyo: Kodansha International, 1995; pp. 967–968. Spoiler: Musashi kills Kojirō. With a sword he carved from a wooden oar. Pretty badass.
² Which is not to say it is as clean as the driven snow. See nuance, above.
³ If you remember nothing else of this screed, remember this. Tattoo it on your forehead, backwards, so you can remind yourself of it in the mirror every morning.
⁴ Update January 16, 2012: A clever and observant critic writes to inform me that, mirabile dictu, August is actually the wettest month in the Sahara, and June is usually the driest. I might claim simple ignorance, which serves me well often, but skeptics among you might suspect my original phrase was a dastardly investment banker ploy to take credit for the rather common as the miraculous: “Well, Mr. Client, you know it almost never rains in the Sahara in August, but through my heroic efforts we were actually able to summon this tremendous monsoon for your benefit. Now, can we talk about fees?”

© 2012 The Epicurean Dealmaker. All rights reserved.

The Root of Some Evil

noreply@blogger.com (The Epicurean Dealmaker) — Mon, 09 Jan 2012 02:37:00 +0000

“It has always seemed strange to me,” said Doc. “The things we admire in men, kindness and generosity, openness, honesty, understanding and feeling are the concomitants of failure in our system. And those traits we detest, sharpness, greed, acquisitiveness, meanness, egotism and self-interest are the traits of success.”

— John Steinbeck, Cannery Row

To greed, all nature is insufficient.

— Lucius Annaeus Seneca

Professor Ian Tonks—great name, by the way—put up an interesting column at vox today, in which he discusses recent research he and his colleagues have performed into the postulated links between banker compensation and the financial crisis. He cites a number of interesting results, including the fact that pay for all executives and directors at leading UK companies increased at a substantial rate during the decade preceding the crisis, and at a rate well in excess of pay for all employees, and that executives and directors at finance companies were second in total pay only to “non-cyclical services” firms (including food and drug retailers and telecom). But those looking for his research to confirm their belief that banker pay was tightly tied to company performance will be disappointed:

... contrary to the prediction that pay was over-sensitive to short-term performance, we find that the pay-performance sensitivity of banks is not significantly higher than in other sectors, and in general is actually quite low. Across all industries, we find a weak relationship between executive pay and company performance. The estimates suggest that a 10% additional increase in company share price performance leads to a 0.68% increase in the pay of the CEO, which translates into a £3,726 increase in CEO pay at the median level of £543,200.

We report that although the pay-performance relationship is slightly higher in the financial services sector for both total board pay and pay of the highest paid director, the additional sensitivity is not statistically significant, and is still economically very small. This tiny performance-related element of executive pay means that there is little evidence that executive compensation in the banking sector depended on short-term financial performance. In other words, executives were paid irrespective of performance. In which case, it seems unlikely that bankers were incentivised to take risks, and refutes the suggestion that incentive structures in banks could be blamed for the crisis.

In fact, Professor Tonks and his fellow Order of the Phoenix members¹ do find a meaningful correlation between executive and director pay in finance and firm size, which is noteworthy, but the slavering hordes of Occupy Wall Street and well-meaning-but-dim regulators must look elsewhere for evidence that greedy bankster bonuses led to Grandma’s condo in Boca Raton being repossessed.

Problem sorted, right? Not so fast.

* * *

Now, uncredentialed peons like me, who merely work in the industry which everybody and their pet Chihuahua seems to have developed a fully formed opinion on nowadays, do not have pre-publication access to high-powered academic research like that produced by Messrs. Tonks and pals, which is being embargoed from all but fellow travelers in academia. Accordingly, I must read into the Doctor’s slender note some key assumptions about just exactly what sort of data it examined. But, if I read him correctly, I perceive at once a couple of key methodological assumptions which are clearly wrong, and which could have been avoided had the merry researchers simply called a couple of real-life bankers, rather than sallied forth to prove something which makes no sense.

The first problem may be inferred from the Professor’s passing reference to the insignificant correlation between increase in CEO pay and “share price performance.” But if the researchers truly measured “company performance” simply and solely by share price performance, they have got the relationship almost completely ass-backwards. For one thing, everyone who has an even passing acquaintance with the equity markets realizes that public company share prices have only a tenuous, intermittent, and volatile relationship with actual company financial performance.² For another—and because of this—even the dimmest bulb on the compensation committee of a public company realizes that the CEO and other key executives have only limited direct influence on the evolution of the firm stock price, usually limited to jawboning the market that it is underpriced. Accordingly, they prefer to pay executives for performance entirely (or mostly) within their control. The metrics they use to measure performance are financial ones, including but not necessarily limited to net income growth, return on equity, and perhaps others like asset growth and credit strength, as appropriate. Simplifying greatly, the compensation discussion at most firms—public or private, financial or non-financial—usually boils down to a version of this: “Make a lot of money for the firm, chum, and you’ll get paid a lot of coin.” It is company financial performance which matters most to executive pay, not stock price performance.

This is a common failing of many real and pseudo-academic (i.e., consulting firm) approaches to measuring pay for performance among public companies in general. Researchers get confused by the fact that many firms pay executives with heavy allocations of restricted and unrestricted stock and stock options into believing that stock price performance is the chief or even a major criterion Boards use to pay them. But what you pay somebody does not necessarily have much to do with how much you pay them. This is particularly true in finance, where bankers have traditionally been paid oodles of funny money in order to conserve corporate cash, tie their wealth to the future performance of the firm, and prevent them from leaving the firm voluntarily without suffering material damage to their net worth. I also suspect researchers default to share prices as an input variable to their correlation studies because they are easily available. This is a misleading and lamentable bit of laziness which deserves to be stamped out.

Take it from me: stock prices are an unreliable way to measure corporate performance, and they are an absolutely shitty way to predict executive compensation.

* * *

The second methodological problem which this study seems to suffer from is perhaps more common to finance than other industries, especially in the more highly paid investment banking and corporate banking subsegments. For it is an absolute fact that a very large number of employees in your typical investment bank make enormous amounts of money. Not only do many more bankers than populate the executive suite bring home pay packages which could support small villages in Central Austria comfortably—that is, money which looks like “executive-level” pay anywhere else—but often the CEO and other executive officers of an investment bank are by no means the highest paid employees there. In a decent year, hundreds of employees at large investment banks make millions of dollars, and a substantial subsegment of those bring home tens of millions, if not more. If Messrs. Tonks and friends only collated and computed compensation data for named executive officers and non-executive directors—who, by the way, as non-producers are, relatively speaking, low-paid irrelevancies—then they missed the lion’s share of actual compensation going out the door in my industry. That is certainly the impression I get when I peruse Professor Tonk’s slim précis.

And here is the problem with that: all those uncounted flow traders, M&A bankers, structured products professionals, prop traders, leveraged finance bankers, and derivatives marketers—not to mention all the non-executive group and division heads above them—get paid buckets of simoleons for making money for the firm.

* * *

And this is where I part ways with our dear Herr Professor Doktor regarding his conclusion. If I have correctly identified his study’s methodological weaknesses, not only has he measured the wrong independent variable, but he failed to apply it to the entire set of relevant dependent variables. He doesn’t collect the proper financial performance data—the gross revenue and gross profit metrics upon which investment bankers are paid in the real world—and he doesn’t correlate it against the revenue-producing employees who are producing them. Based upon how my industry actually conducts business and pays its employees, he hasn’t proved anything.

Sadly, Your Dedicated and Evenhanded Bloggist, like many others, would still like to see a comprehensive, data-based investigation of the question which Professor Tonks addresses. Unfortunately, I do not know how one could go about this without at least acquiring time series of aggregate payroll data for all revenue-producing employees at each financial firm, correlated against preferably group or divisional level revenue and profit results. You can just imagine how well that request would go over in the offices of Jamie Dimon or Lloyd Blankfein.

For my part, I continue to believe some banker bonuses were indeed contributory to the financial crisis. My industry’s pay practices and culture were built over decades when the vast majority of business investment banks conducted was agency business. Business like M&A, where you earn a fee for helping a client buy or sell a company, or security underwriting, where you earn a fee for placing client securities with outside investors, or securities market making, where you earn a spread for standing between buy- and sell-side investors as a middleman and temporary warehouser. None of these businesses entailed any material amount of persistent or hidden financial risk to investment banks: we did the deal, we got paid, and we moved on. There are no meaningful, dangerous “tail” exposures from such activities. Accordingly, investment banks got used to toting up the profit and loss for each banker and each business line at the end of each year and paying out a percentage of that as compensation to the people who either brought the money in or who could argue most persuasively they had. Simple.

The problem arose when investment banks (and their bastard cousins and often ultimate owners, commercial or universal banks) began conducting business as principals, either explicitly and in full knowledge, or—most dangerously—in total ignorance. Mouthwateringly profitable leveraged lending, structured products, complex derivatives, and proprietary investing of all kinds meant that investment banks no longer conducted business as short-term conduits of temporary risk, but began accumulating long-term financial risks on or off their balance sheet, often without their own knowledge. But when this happens, the old view that Joe in Structured Products should get a massive bonus in February because he brought in $100 million of fee revenue to the firm this year cannot cope with the fact that Joe’s fabulous trades expose the firm to $1 billion in potential losses over the next five years. Even if some investment banks did develop robust and accurate risk-pricing models which accurately tallied and kept track of the massive tail risks metastasizing on their balance sheets—and recent history puts this assertion in considerable doubt—almost none of them drew the connection to compensation practices. Projected firm profits on trades like Joe’s should never be totaled up front when determining Joe’s pay; they should be amortized over the life of the potential risks the ongoing trade poses to the firm. Most banks just didn’t seem to get this important point.³

* * *

There really is a story to be told in here, somewhere, about exactly how and how much banker bonuses contributed to the aggregation of huge hidden and misunderstood risks in the global financial system. From what I can glean from limited evidence, Professor Tonks’ study is not it. Perhaps one day some academic will actually make the effort to understand how my industry works before they design a study to explain it.

Naahh.

Related reading:
Ian Tonks, Bankers’ bonuses and the financial crisis (vox, January 8, 2012)

UPDATE January 10, 2012: Subsequent to the initial publication of this piece, certain readers inside the sanctum sanctorum of the academic priesthood (or their acolytes) were so exceedingly kind as to direct me to the prepublication version of Professor Tonks et al.’s paper, here. As I suspected, this merry band of scholars only looked at aggregate director pay and highest director pay (usually, but not necessarily, the CEO) as dependent variables, and did not examine compensation to revenue producing ranks within financial institutions. This, as I explain above, is simply and irrevocably wrong. I also can confirm these scamps measured company performance primarily by calculating total shareholder return, based upon the following logic:

The most important measure of company performance is the total shareholder return, since the purpose of performance-related pay is to align the interests of the directors with those of the shareholders.

But this, as I outline above, completely begs the question of how bankers actually are paid and replaces it with the hoary old shibboleth about how they should be paid. This is not research; this is theology. The academics also did try to correlate director pay to slightly less silly measures, like earnings per share, return on assets, and revenue growth, but presumably they found little enough correlation between these variables and Board pay either. As I explain at nauseating length above, they were simply looking in the wrong place(s).

My arguments and conclusions remain unchanged.

¹ Gratuitous Harry Potter reference. Sorry.
² Consider, for example, what happens when a company posts impressive, even record, financial results (most usually net income growth) but fails to meet or exceed investor expectations: the stock price goes down. Consider, as well, a company which posts exceptional results in a falling market: more likely than not, the stock price falls then, too. Stock price is a lousy short-term and even intermediate-term indicator of absolute financial performance, if for no other reason than stock price is (supposed to be) a forward-looking measure, and financial performance is backward looking. Lots of academics seem to have trouble grasping this distinction.
³ And paying Joe 30–50% of his total compensation in unvested stock and options didn’t help much either. Sure, he had to stick around to cash it in, and therefore he was concerned with the continued existence and good stock price performance of his employer, but neither of those things are much that Joe, or anyone else not in the executive suite (and sometimes even there), can do much about. Long-term stock compensation is a pretty weak disincentive to risk-taking; producers like Joe focus much more on booking huge profits—and hence huge bonuses—right now, and devil take the hindmost. I confess I have occasionally argued the opposite side of this too strenuously in the past.

© 2012 The Epicurean Dealmaker. All rights reserved.

Turn the Page

noreply@blogger.com (The Epicurean Dealmaker) — Sat, 31 Dec 2011 19:46:00 +0000

“Everybody’s coming back to take stock of their lives. You know what I say? Leave your livestock alone.”

— Grosse Pointe Blank

One more rotation of a small blue planet on its circuit around a minor yellow star at the edge of an unremarkable galaxy in an accidental universe is flimsy justification for the importance which so many of us put on the turning of the year. But we have agreed to take this day and night as a sign of something larger, something more important than our quotidian lives. It is simple convention, yes, but it is our convention. And who is to say we are wrong?

So raise a glass: To absent friends. To present friends. To family and everyone else we love. To life, and the chance to keep on living it, if only for a little longer (who knows how long). To paths taken, and untaken. To the promise and hope of a new year. To the wishes in your heart. To the hopes of all humankind.

To the words and motions of that ancient toast:

Never above you,
Never below you,
Always beside you,
And forever in your glass.

Happy New Year.

Two roads diverged in a yellow wood,
And sorry I could not travel both
And be one traveler, long I stood
And looked down one as far as I could
To where it bent in the undergrowth;

Then took the other, as just as fair,
And having perhaps the better claim,
Because it was grassy and wanted wear;
Though as for that the passing there
Had worn them really about the same,

And both that morning equally lay
In leaves no step had trodden black.
Oh, I kept the first for another day!
Yet knowing how way leads on to way,
I doubted if I should ever come back.

I shall be telling this with a sigh
Somewhere ages and ages hence:
Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.

— Robert Frost, “The Road Not Taken”

Shhh!

noreply@blogger.com (The Epicurean Dealmaker) — Sat, 31 Dec 2011 05:01:00 +0000

Je souhaite dans ma maison:
Une femme ayant sa raison,
Un chat passant parmi les livres,
Des amis en toute saison
Sans lesquels je ne peut pas vivre.

In my house I wish:
A woman with her reason,
A cat passing among the books,
Friends in every season
Without which I cannot live.

— Guillaume Apollinaire, “Le Chat”

Enjoy your weekend.

© 2011 The Epicurean Dealmaker. All rights reserved.

In the Nation’s Service

noreply@blogger.com (The Epicurean Dealmaker) — Thu, 29 Dec 2011 20:49:00 +0000

“They all have husbands and wives and children and houses and dogs, and—you know—they’ve all made themselves a part of something, and they can talk about what they do. What am I gonna say? ‘I killed the President of Paraguay with a fork. How’ve you been?’”

— Grosse Pointe Blank

It is a common situation in human society that we often encounter significant moral dilemmas, situations in which we must make a choice between terrible evils in order to advance some agenda. Should we continue an unjust war when immediate cessation could cause worse harm than a temporary continuance? Should we torture a prisoner for the location of a nuclear device primed to incinerate innocent civilians? Should bankers crash the entire global financial system and plunge us into recession simply to ensure a steady stream of material for journalists and pundits to write about? These are difficult choices.

Within larger, more complex societies, we often deal with such regularly recurring dilemmas by establishing and empowering groups of individuals to take care of our dirty work for us. Whether it is Seal Team Six, the United States Congress, or Goldman Sachs, many of us prefer to tut-tut from a safe distance about the naughty things these agents do to advance our interests, while secretly enjoying both the benefits they help provide and the fact we ourselves are able to maintain righteously clean hands while doing so. I leave it to you, O Thoughtful Readers, to reflect on the justice of such moral hypocrisy and, indeed, whether is it truly avoidable in any practical sense.

More to the point, however, is the question whether such groups and individuals actually provide a service to their societies. I say they do. You may not agree with their actions, or even the sociopolitical agenda which engenders such choices, but you cannot deny that society as a whole depends and relies upon such agents to do its dirty work. And there is plenty of dirty work to go around. Some claim, for example, that the entire industry of financial intermediation “is a superposition of fraud and genius” designed to trick the rest of us into taking investment risk, therefore ensuring economic growth instead of collective stasis, even if the price is unequal distribution of risk and loss and the extraction of intermediary rents by financiers. This may well be true. But it is a collective fraud which advanced societies have foisted upon ourselves, and in most instances we enjoy substantial (if not unalloyed) benefits from it. What would you propose in its stead? Lower living standards?

And even if you are skeptical that the financial industry’s actions are the moral equivalent of shooting terrorists in the head or firing remote-controlled missiles into Afghan villages—as I am—you can still acknowledge that perhaps the societal function it performs, while unpleasant, is one of more pedestrian utility, like taking out the garbage or cleaning toilets. Call it the “wrinkled nose” problem. There are lots of those jobs which need to be filled in society. In fact, one might argue that most jobs fall somewhere along the spectrum from mildly disgusting to slightly repellent in moral terms. As a wise man once observed, that’s why they call it work.

So I fear I must take exception when Princeton students exhort their peers to eschew jobs on Wall Street for more noble ones “In the Nation’s Service.” We all work in the nation’s service, children, whether you like it or not: garbagemen, IRS agents, commando assassins.

Even investment bankers.^1,2

II.

There is another, more prominent strain to the critique of Wall Street’s hiring among college students. That is, it is argued that the financial industry is so lucrative and glamorous that it has—at least for the past many years—hoovered up all the “best and brightest” among this nation’s young people, leaving too few for the really important work of innovating, inventing, producing, and addressing the truly pressing problems our society faces. The example typically used to illustrate this argument is the large number of science, math, and engineering graduates Wall Street has hired into sales and trading positions to construct, market, and trade structured products and derivatives.

Put aside, for a moment, the question whether we really face a shortage of technically trained young people in science, math, and engineering roles in this country when we can afford to devote a significant number of them to programming virtual farm animals and glorified online diaries. Put aside the question why the supposedly daunting technical problems we face are not serious enough to have created well-paid jobs for hundreds of otherwise unemployed, highly-educated PhDs in science and engineering. Put aside the fact that many of these wonderfully innovative and productive jobs are either highly risky entrepreneurial positions with no financial security or low-paid internships with charitable organizations or NGOs. Put aside, in other words, the fact that no-one has demonstrated to me that there is any real demand out there in the real economy for these supposedly “productive” positions, or at least any demand that can translate into a living wage sufficient to support a young college graduate without her having to live in her parents’ basement. No, we can address the larger argument directly with several different points.

First, there is the simple matter of demand. Wall Street and finance are currently shrinking rapidly, due to a combination of lousy cyclical market conditions and hostile secular regulatory shifts. Simply stated, Wall Street will continue to shrink over the next several years, because we can no longer make the kind of money structuring, selling, and trading securities and derivatives we did before the financial crisis. We just won’t need to hire as many people as we did in the last decade. Most of the best and brightest will have to look elsewhere for job offers anyway. Problem sorted.

Second, it is not clear that finance ever did monopolize hiring of the best and brightest among our young people, anyway. There are two components to this observation. As Bryan Caplan observes, “elite”—that is, lucrative and socially prestigious—employers like investment banks and management consulting firms tend to recruit new hires from a very narrow and select list of undergraduate and graduate schools, consisting primarily of the Ivy League and cognate institutions. Investment bankers and management consultants tend to look for new employees like themselves, and they tend to be more comfortable recruiting either from the schools they went to or from schools just like them. But, as Megan McArdle points out,

The Ivy League is full of smart, interesting people. But it is not full of all of the smart, interesting people in the country, or even a majority of them. And given the résumés required to get there, it produces a group of people who are narrow in certain predictible ways. (I include myself in this: just because I can see it operating doesn't mean I can escape it.)

The problem is that actually seeking out a wide variety of graduates would be much more expensive and time consuming. Why spend the effort searching for “best” when you can easily access “very, very good”?

This is spot on, as I can attest from my own experience. Over the years, my employers, peers, and I have been completely uninterested in recruiting the “best and brightest” from among the flower of our youth. Instead, we look for bright enough (i.e., very, very bright, but not necessarily the brightest), very hard working, and supremely ambitious. This is entirely due to the requirements of the jobs we hire for: we need young men and women with quick, flexible intellects who can pick up the tricks of the trade in very short, very accelerated apprenticeships; people who are gregarious and fun to be with at 3:00 in the morning after three all-nighters together; and people who are phlegmatic and driven enough to withstand the inhuman punishment we dish out during the early years of their careers. The nature of investment banking—and, dare I say it, management consulting, too—is not one that demands deep thinkers, brilliantly inventive innovators, or even virtuoso synthesizers of disparate intellectual strands. We want smart, fun, dedicated, aggressive youngsters who can work like animals, day-in, day-out, for as long as it takes. As you can tell, this is not a particularly nuanced or diverse set of criteria.

At most you can say that, up until now, investment banks have been aggressive employers of a particular kind of person from among the best and brightest, and they have sought their candidates from among a particular subset of educational institutions which generate them. The intense selectivity of the most elite universities in this country guarantees that there a legions of brilliant, driven, accomplished youngsters stretching their intellects and learning valuable skills outside the penumbra where Wall Street looks for its hires. Furthermore, as Megan McArdle says, the eye of the needle through which young people must pass to gain entrance to the Ivy League and other super-elite universities tends to select for just the sort of highly ambitious, aggressive individuals who make good candidates for investment banking.³ This leaves a tremendous number of highly intelligent, creative, and non-conventional individuals firmly outside the clutches of evil investment banks, whether they like it or not. Those who despair that the cream of our youth are disappearing down the maw of Mammon should take comfort that a very large number of them—probably the majority, and perhaps even the best of the best and brightest, given what we want them for—escapes permanent dissolution into ignominy.

Finally, even those who fall into the gaping gullet of finance are not necessarily lost forever. Students hired out of college are typically employed for two years at most, after which they can leave to go to graduate school or rejoin the productive economy, wiser for their scars and sporting a highly marketable work experience on their résumés. Even among those who go to business school, not all return to my industry. Ones who stay or return with MBAs don’t all stay forever, either. They get fired or laid off; they burn out under the unrelenting strain; they become disgusted with the miserable lifestyle, the continual sacrifices, and/or the moral compromises they feel compelled to make. The ones who manage to make full careers in my business are few in number, even though a “career” in my business normally lasts less than 20 years. Investment banking is a young person’s game, or the calling of an individual like me who has found nothing more exciting and satisfying to do that will actually pay him money. Some—a very few—even manage to come out the other side of the tunnel with their morals intact and the financial security and means to give back to society in a meaningful way. They go into politics, they become philanthropists, they build schools in Bolivia.

They might even write a blog.

III.

So, don’t despair. The deluded and confused flower of our youth will have broader, more socially constructive paths available to them than investment banking, whether they want them or not. Investment banks’ demand for cannon fodder is plummeting almost as fast as their social prestige, and pay is likely to follow. Eventually, unless current trends reverse, investment banking will return to what it was not so long ago: an obscure, thinly peopled backwater too mysterious for most trend-following college kids to even contemplate, and too abhorrent in polite society for their parents to recommend. The hard-core wanna-be bankers—high-functioning autistics, budding psychopaths, etc.—will always beat a path to our doors, however, as they always have done. And we will welcome them with open arms. Perhaps even motivated, intelligent candidates from non-Ivy schools will have a chance to break in, too, after the Ivy Leaguers have moved on to the next hot employment trend. That would be a good thing, since they tend to be better candidates for the long run anyway.

We don’t need or want all the best and brightest. Just the best and brightest investment bankers. Not much has changed in that regard over the past 20 years I have been in the saddle. But one thing has changed for good, and for the better. No longer can a privileged dilettante get a job at Salomon Brothers simply because Mummy knows the Queen of England. Sorry, Michael Lewis.

Related reading:
Steve Randy Waldman, Why is finance so complex? (Interfluidity, December 26, 2011)
Kevin Roose, An Orange and Black Eye for 2 Banks (DealBook, December 9, 2011)
A Hard Rain’s Gonna Fall (September 30, 2011)
Bryan Caplan, How Elite Firms Hire: The Inside Story (EconLog, November 18, 2011)
Megan McArdle, Elite Firms Fishing in a Very Small Hiring Pool (The Atlantic, November 18, 2011)
If the Phone Don’t Ring, You’ll Know It’s Me (October 1, 2011)

¹ Which is not to say, of course, that we must allow the people who do our dirty work to do whatever they want or abuse their legal and extralegal powers for their own benefit and the detriment of the greater good. After all, we empowered them. They work for us. So it is up to us to direct and monitor what they do and are allowed to do. In the case of the financial system, this means regulation and oversight. I have consistently advocated close, stringent regulation of the financial sector, for the very reason that a malfunctioning, overly self-interested financial system can cause all kinds of nasty problems. As I think we all can attest.
² Furthermore, when students such as these talk about jobs in the nation’s service, they most often mean civil service, bureaucratic, and political positions. Oftentimes, these are the very individuals who commission society’s dirty work in the first place. Who is more culpable, the commando who shoots the terrorist in his bed, or the National Security Advisor who authorized the raid? The structured products banker who sold toxic securities, or the stream of regulators and politicians who loosened the rules enough for him to get away with it? Hmm...
³ The most select schools make heroic attempts to enroll diverse student bodies, and they certainly have the numbers of applicants to make that possible. However, the center of the bell curve at any Ivy League university remains squarely in the sights of my industry, and it is arguable that pressures both within and after school tend to push everyone toward the middle. There was a humor book in the 1980s, The Preppy Handbook, which joked that 20% of each entering class at Princeton were preppies, but 80% of graduates were. One might say the same thing about students who want jobs in investment banking and consulting nowadays.

© 2011 The Epicurean Dealmaker. All rights reserved.

TED’s Greatest Hits of 2011

noreply@blogger.com (The Epicurean Dealmaker) — Mon, 26 Dec 2011 18:40:00 +0000

True, true, 2011 isn’t officially over yet, but I am happy to hurry the good-for-nothing wastrel out the door. What promised to be a busy and productive year in my business fizzled out pathetically after Labor Day, leaving me far too much time to blog for my own comfort. Readers continued to trickle in to this site over the course of the year, however, so either I must be doing something right here or there are vastly more masochists peopling the world than I ever suspected.

While the following 10 “most popular” blog posts from 2011 are not based on anything more scientific that Google Analytics page rankings,¹ they are not an unfair representation of the general tenor, topics, and tone of my work. Feel free to while away the interstitial period before the official beginning of the Mayan Year of Catastrophe by revisiting the pieces below (or diving in for the very first time). As a special, one-time, limited holiday offer, there is no charge.

Enjoy.

THE CANON, 2011 Edition

1) Jane, You Ignorant Slut (May) — In which I trenchantly and comprehensively respond to some of the idiotic gasbaggery circulating the interwebs over the pricing of LinkedIn’s initial public offering. Targets for my righteous fury include the normally sensible Joe Nocera, intermittently unhinged Jim Cramer, and former investment bank research analyst² and current blog spammer Henry Blodget, whom I take to task for promulgating “The Stupidest Analogy About IPOs Ever Conceived.”™ Due in no small part to the fact that Mr. Blodget took umbrage at my attack and attempted to paint himself out of the ridiculous metaphorical corner he had invented in a follow-on post, this article attracted by far the greatest number of pageviews of any individual post during 2011. It also reaffirmed my long-standing policy of preventing comments at this location to be the only tenable one for an individual uninterested in marinating himself in the idiocy of the legions of mouthbreathers and internet trolls which populate one of the leading business-oriented blog sites in the English language.³

2) First, Let’s Shoot All the Philosophers (April) — The head of the Department of Philosophy at UNLV argues that the study of philosophy should be supported at his university due to its practical benefits, and I counter that the salient characteristic of philosophy is exactly its radical non-practicality. Picked up like a shiny new toy for some reason by folks over at ycombinator, whose inclusion of this piece on their news feed drove thousands of unsuspecting hackers, venture capitalists, and other hapless start-up junkies to a site which they could only have been too happy to leave as quickly as possible.

3) Come Fly With Me (February) — Wherein I puncture the twin myths of the glamor of investment banking travel and the independence of Big Swinging Dicks like me. It’s a client service business, people, after all. Complete with a nifty cinéma vérité snap by your very own Dedicated Bloggist and Budding Professional Photographer.

4) Bar Nothing (January) — An autobiographical anecdote from serial confessor James Altucher forms the basis for this meditation on the attractions of “hot clients” and “hot deals,” which together reduce normally dignified, self-contained, and highly principled investment bankers⁴ to slavering crack whores desperate for a hit. Illustrated with a spiffy pic of Rita Hayworth as Gilda, sadly not taken by this Author.

5) If the Phone Don’t Ring, You’ll Know It’s Me (October) — For all those eager beavers who continue to want to break into my industry—regardless of parental advice, social opprobrium, and diligent demythologizing by Yours Truly—I lay out a few pointers which might do the silly buggers some good. Hint: an Ivy League degree in finance is not required.

6) Dan, You Pompous Ass (May) — A follow up post to my original LinkedIn IPO piece (q.v. #1, above), in which I provide more details of the IPO distribution process while simultaneously debunking the notion that the fact that investment banks treat institutional buy-side investors differently reflects underhanded or illicit behavior. As I did not bother to attack Henry Blodget again by name in this piece, pageviews were materially lower. Paraphrasing Jane Austen, I hope and suspect Mr. Blodget was so perfectly satisfied with our first conversation that he will never again distress himself by introducing the subject of it again.

7) She’s Got Legs (June) — In which I offer fashion advice to aspiring young women in my industry and similar ones. Said advice mainly boils down to the following: “sexy” ≠ professional. Period.

8) A Victim of Soycumstance (September) — Your Diligent Reporter spotlights a story on divisional infighting at Morgan Stanley to explain why the historically contentious and structurally conflicted corporate finance and sales & trading divisions of traditional investment banks do much better when they cooperate. Encompasses both management philosophy & practice and firm strategy in investment banking, which may be the first time anyone in my industry has ever actually thought about the two topics together.

9) You’re Doing It Wrong (October) — Your Humble Blogosophist loses patience, once again, with the pace and direction of financial reform in this country. I spray the landscape liberally with machine gun rounds, in hopes of winging a recalcitrant legislator or lobbyist or two, but I fear the result will once again be for naught. Pretty much summarizes the kind of regulatory regime I think would work, though. For the archives or for shits and giggles, depending on your preference.

10) A Hard Rain’s Gonna Fall (September) — Sales and trading professionals are getting fired by the thousands, in a massive bloodletting designed to shrink that overgrown side of the house back to normal after years of cheap credit, massive investment flows, and lax regulation. So, what’s a clever sales and trading manager to do? Plant stories in the gullible media attacking mergers & acquisition advisors, of course. Being one of the latter, I fight my corner. I think I win.

* * *

Let’s all hope 2012 won’t be such a pisser. Here’s mud in your eye!

¹ Approximately 185,000 pageviews came in over the course of the year to the home page of this blog and are therefore not identified with any one post. Splitting these up equally over the total number of posts this year gives a page view count per page roughly equivalent to the identified page views for the tenth-ranked post above. Which is only to say, I have no fucking idea what you people like to read.
² Who, one would think, should know better.
³ Yes, you may take that last bit as ironical.
⁴ I’m pretty sure there is more than one of these in my industry.

© 2011 The Epicurean Dealmaker. All rights reserved.

As Good as It Gets

noreply@blogger.com (The Epicurean Dealmaker) — Mon, 26 Dec 2011 14:58:00 +0000

Carol Connelly: “OK, we all have these terrible stories to get over, and you...”
Melvin Udall: “It’s not true. Some of us have great stories, pretty stories that take place at lakes with boats and friends and noodle salad. Just no one in this car. But, a lot of people, that’s their story: good times, noodle salad. What makes it so hard is not that you had it bad, but that you’re that pissed that so many others had it good.”

— As Good as It Gets

Here’s wishing all of you lots of noodle salad in 2012.

Happy New Year.

© 2011 The Epicurean Dealmaker. All rights reserved.

Walking Song

noreply@blogger.com (The Epicurean Dealmaker) — Sun, 18 Dec 2011 21:47:00 +0000

I sit beside the fire and think
of all that I have seen,
of meadow-flowers and butterflies
In summers that have been;

Of yellow leaves and gossamer
in autumns that there were,
with morning mist and silver sun
and wind upon my hair.

I sit beside the fire and think
of how the world will be
when winter comes without a spring
that I shall ever see.

For still there are so many things
that I have never seen!
in every wood in every spring
there is a different green.

I sit beside the fire and think
of people long ago,
and people who will see a world
that I shall never know.

But all the while I sit and think
of times there were before,
I listen for returning feet
and voices at the door.

— J.R.R. Tolkien, The Fellowship of the Ring

NGC 6302 is a gaseous nebula in the constellation Scorpius which surrounds an immensely hot white dwarf star. It has one of the most complex planetary nebula structures known. The cloud is unconscionably gigantic, with lobes extending out as far as two light years (12 trillion miles) from the central star. Given that it is located approximately 3,400 light years (20.4 quadrillion miles) from Earth, it is in no conceivable way a structure which I will ever have the opportunity to visit, even if someone invented fast-as-light space travel tomorrow. Add to this the fact that the photons we see today left the nebula over three thousand years ago, and it is also true that the nebula as it exists now no longer looks like the picture above.

It is both a wonder and a sadness that we humans have developed brains which can conceive of a universe so vast as to literally be forever beyond our individual grasp. I suspect we are the only species on this planet which can not only contemplate our own individual extinction—intellectually, if not emotionally—but also conceive of a future world—happy, beautiful, alive—without our own presence. We need not turn our eyes to the stars to do so, either.

What will the world be like when winter comes without a spring that I shall ever see? What will my children and grandchildren and future generations of human beings see, and do, and experience? How I should like to see what they will see.

How I should like to see just one more spring after my last winter.

© 2011 The Epicurean Dealmaker. All rights reserved.

Miss Lonely Hearts

noreply@blogger.com (The Epicurean Dealmaker) — Sat, 26 Nov 2011 18:19:00 +0000

From time to time, O Dearly Beloved, your Faithful Correspondent receives a letter in the electronic mailbag which he decides is worthy of more general airing in these pages than a simple direct reply.

Today’s specimen wends its way to the Volcano Lair from a junior investment banker of the distaff persuasion (let us call her “Tempted”). She solicits my advice on whether a workplace dalliance with a more senior colleague, one who is already in a committed relationship, would have a detrimental or indeed even positive effect on her professional advancement. She acknowledges being attracted to said individual, finding both his attentions pleasing and his person enticing.

As this situation is quite common in my industry—and, I imagine, many others—for reasons which I outline below, I thought it might be helpful to publish herewith a lightly edited version of the reply I sent Tempted earlier today.

Dear Tempted — Speaking purely from a professional perspective, which you seem to want me to do, screwing around with this guy sounds like a really bad idea. Some random thoughts:

Sleeping with a woman does not raise a man’s professional opinion of her. Ever. Unless she is a prostitute.

Sex, emotions, and relationships are messy. How would you keep this quiet at your firm? Office romances get out. You won’t be able to prevent it.

You say he is smart and cute, and his attentions flatter your vanity. I expect you appeal to him at least in part because he is in a position of power and authority (or at least seniority) to you. This sounds like a lousy basis for a work relationship, or indeed any sort of relationship.

If your firm employs more than 100 people, it will likely have explicit guidelines about intra-office romances, especially among people who work together. Check them out. You and your colleague might be violating workplace rules by proceeding.

Sleeping with a more senior banker will earn you a reputation as someone who sleeps your way to the top. This is a really shitty reputation to have, whether among men or women, especially if it is not true.

You will likely get the short end of any stick in this situation. He has a permanent job and an established reputation at your company. You don’t. If push comes to shove, you are the one who is likely to get the boot.

Odds are most relationships at your age don’t last. Unless both of you are truly in love—and it sure doesn’t sound that way—it will not last. How will you be able to work together in the future? Never underestimate how knowing how someone looks naked or what embarrassing little quirks they have in bed can undermine a professional working relationship.
I recommend you extract yourself gently from any real engagement with this guy. Remind him of his girlfriend, tell him you’ve met someone special, tell him you’re worried how this will affect your chances at the firm, anything. You can flirt with him—mildly—but for heaven’s sake keep your clothes on. Unless you both fall madly in love—in which case one or both of you shouldn’t care about getting new jobs elsewhere, as you will likely have to do—this is a really bad idea.

I would offer you this same confidential advice if you worked for me and came to me in person. Good luck, and be careful.

TED

* * *

Now, don’t get me wrong. I love sex. Sex is a wonderful thing, and one of the few unalloyed perks of being human, in my opinion. If I had my druthers, I wouldn’t give a rat’s ass whether all the healthy young girls and boys who work for me fucked each other like bunnies all the time they weren’t in the office. Why, I might even set up a mattress in the break room so they could sneak off for a little horizontal tango during lunch hour, just so they could work the nasty into their work schedules more efficiently.

And it is no surprise temptation is there. Throw together smart, attractive, ambitious, and energetic young men and women (or men and men, or women and women, for that matter)¹ for 16 hours a day of high-pressure, high-stakes work seven days a week, 52 weeks a year. Make sure they develop an elite esprit de corps of shared suffering and accomplishment, compounded by societal envy and disapproval of what they do, and give them rare opportunities to blow off steam together in dark nightclubs and bars and the company of way too much alcohol. It’s a wonder every female investment banker under the age of 30 isn’t pregnant all the time.

But sex is messy. Sex is tangled up with all sorts of emotions, good and bad, and sex makes for a very awkward work environment. It is the rare couple who can conduct an affair at work that does not spill over into recriminations, drama, and undermining behavior, and that is just among their coworkers. In a work environment, sex fucks things up. As a boss, I won’t tolerate it. I just have too much goddamn work to do.

So keep it in your pants, boys. Keep your legs crossed, girls. At least with each other. Because if anything interferes with getting that big LBO pitch for Yahoo! done this weekend, I swear I will fucking geld you.

Related reading:
She’s Got Legs (June 11, 2011)
Thank You for Smoking (August 6, 2010)
Fingernails that Shine Like Justice (May 21, 2007)

¹ Hey, whatever floats your boat. I don’t care. I would simply observe that gay men and lesbians tend to be even scarcer in my industry than straight women.

© 2011 The Epicurean Dealmaker. All rights reserved.

The Cold Companionable Streams

noreply@blogger.com (The Epicurean Dealmaker) — Fri, 25 Nov 2011 20:07:00 +0000

The trees are in their autumn beauty,
The woodland paths are dry,
Under the October twilight the water
Mirrors a still sky;
Upon the brimming water among the stones
Are nine-and-fifty swans.

The nineteenth autumn has come upon me
Since I first made my count;
I saw, before I had well finished,
All suddenly mount
And scatter wheeling in great broken rings
Upon their clamorous wings.

I have looked upon those brilliant creatures,
And now my heart is sore.
All’s changed since I, hearing at twilight,
The first time on this shore,
The bell-beat of their wings above my head,
Trod with a lighter tread.

Unwearied still, lover by lover,
They paddle in the cold
Companionable streams or climb the air;
Their hearts have not grown old;
Passion or conquest, wander where they will,
Attend upon them still.

But now they drift on the still water,
Mysterious, beautiful;
Among what rushes will they build,
By what lake’s edge or pool
Delight men’s eyes when I awake some day
To find they have flown away?

— William Butler Yeats, “The Wild Swans at Coole”

Which is the more difficult duty: to leave too soon, or to stay behind, unable to follow? Stupid question, for each of us will assume both burdens soon enough, and likely much too soon.

Rest in peace, absent friends.

Live unwearied in love, joy, and passion, present ones.

© 2011 The Epicurean Dealmaker. All rights reserved.

Holiday Interlude

noreply@blogger.com (The Epicurean Dealmaker) — Thu, 24 Nov 2011 04:10:00 +0000

I’ve seen things you people wouldn’t believe. Attack ships on fire off the shoulder of Orion. I watched C-beams glitter in the dark near the Tannhauser gate. All those moments will be lost in time... like tears in rain...

— Blade Runner (1982)

The flesh surrenders itself, he thought. Eternity takes back its own. Our bodies stirred these waters briefly, danced with a certain intoxication before the love of life and self, dealt with a few strange ideas, then submitted to the instruments of Time. What can we say of this? I occurred. I am not... yet, I occurred.

— Frank Herbert, Dune Messiah

How can we endure? How can we ensure all our moments will not be lost, like tears in the rain? Does it help to share those moments with others, to pass the baton, as it were? Perhaps. It is pretty to think so.

Here is better advice: Occur well.

Happy Thanksgiving.

© 2011 The Epicurean Dealmaker. All rights reserved.

Sovereign Triviality

noreply@blogger.com (The Epicurean Dealmaker) — Sun, 20 Nov 2011 00:50:00 +0000

Above all else, the mentat must be a generalist, not a specialist. It is wise to have decisions of great moment monitored by generalists. Experts and specialists lead you quickly into chaos. They are a source of useless nit-picking, the ferocious quibble over a comma. The mentat-generalist, on the other hand, should bring to decision-making a healthy common sense. He must not cut himself off from the broad sweep of what is happening in his universe. He must remain capable of saying: “There’s no real mystery about this at the moment. This is what we want now. It may prove wrong later, but we’ll correct that when we come to it.” The mentat-generalist must understand that anything which we can identify as our universe is merely a part of larger phenomena. But the expert looks backward; he looks into the narrow standards of his own specialty. The generalist looks outward; he looks for living principles, knowing full well that such principles change, that they develop. It is to the characteristics of change itself that the mentat-generalist must look. There can be no permanent catalogue of such change, no handbook or manual. You must look at it with as few preconceptions as possible, asking yourself: “Now what is this thing doing?”

— Frank Herbert, “The Mentat Handbook,” Children of Dune

While I do my best to suppress such realizations, Dear Readers, I have found it increasingly difficult to deny that we live in an age of Engineering and Science triumphalism. Signs abound for all to see, from technology’s relentless conquest and absorption of everyday human interaction, to the increasingly strident complaints that my own industry has hobbled the march of civilization by luring innocent youth away from test tubes and argon lasers and perverting them to the “socially useless” worship of Mammon. It is perhaps no stronger evidence that Science with a Capital S has consumed the heart of our common narrative that so many of the culturally and intellectually dispossessed have been fighting so fierce a rearguard action in denial of its most basic claims. Flat Earthers are never more strident or dangerous than when they feel their very relevance to society is threatened.

Within the mainstream conversation, however, there seems to be a general consensus that as a country we neither possess nor produce enough scientists and engineers to meet our current and projected challenges, so many of which are asserted to be scientific or technical in nature. Climate change, pollution, adequate energy, population pressures, poverty—all these and more are asserted to be in some form or fashion reducible to technical problems. Problems which, many seem to assume, can be solved if we simply graduate more scientists and engineers to fix them (and make sure they don’t go to Wall Street). Let us birth more Steve Jobs and Mark Zuckerbergs, the argument goes, and all will be well.

Accompanying this narrative, of course, is a general wailing and gnashing of teeth that we devote too many resources within higher education to the teaching of the liberal arts and humanities, resources which could be better allocated to training the technicians, engineers, and scientists we really need. Now, as a fierce devotee of the liberal arts and humanities in my own right—and, in full disclosure, a graduate with a degree in a traditional “soft” social science—I am understandably partial to arguments which refute such heresy. Sadly, the few examples I have seen so far¹ have done little to press what I consider the strongest arguments in favor of maintaining broad and robust humanities programs in higher education.

The weakest are of a kind: arguing the instrumentalist case that liberal arts disciplines can be functionally useful to society, either in their own right or as producers of the junior partners—translators, communicators, panegyrists, and apologists—for the scientists and engineers who do the “real” work. But this will not do. That way lies intellectual stepchildren like “Applied Philosophy” and “Science Journalism,” fine professions no doubt, but hardly compelling enough societal amanuenses to justify $200,000 bachelor degrees and ongoing taxpayer subsidies.

Writing in The Economist, Will Wilkinson supplies stronger arguments. He points out that college, for most, is now a major consumption good, which students exploit because they can. He flips Alex Tabarrok’s argument of education in the service of economic growth on its head:

What is economic growth for, anyway? It’s for expanding our choices and making life better. Is it really so surprising that, as we grow wealthier as a society, more and more of our young people, when the amazing resources of the modern university are put at their disposal, choose to use them learning something satisfying and enriching and not for anything except cherishing the rest of their lives? Is it really so surprising that taxpayers are not in revolt over the existence of poetry professors?

He also makes the more germane instrumentalist point that, as Western society gets richer, we expend more and more leisure time consuming the products of artists, writers, and other creative folk. Who else but Film Studies and Comparative Literature majors will produce these entertainments, anyway? Physicists? Mechanical Engineers? Please.

* * *

But all these counterattacks miss the three most important reasons I believe broadly available liberal arts education will remain critical to our society and polity for the indefinite future. First, there is the point which Frank Herbert makes so artistically and metaphorically in my epigraph above. As the body of scientific and technical knowledge swells exponentially, scientists and engineers by definition simply must become narrowly focused specialists. You cannot be effective as a scientist or engineer nowadays if your knowledge spans too broad a field. Our collective scientific knowledge is simply too deep. But this introduces the dilemma of the expert, who literally cannot see the forest for the trees or, more aptly, for the respirative pores on the bottom of leaf #6,972 on branch #473 of tree #1,204. Who will aggregate and balance the competing viewpoints, suggestions, and research programs of all these specialists in highly complex microdomains? Who else but someone who has been rigorously educated in the general discipline of how to think, of how to evaluate competing claims and conflicting evidence under conditions of extreme uncertainty? Who has been taught not only how to analyze and synthesize disparate, incompatible, and even conflicting data but also how to judge?²

The second point to realize is that the usual suspect scientific and technical conundrums which the techdysiasts would have us address are defined and constrained far more by their social and political dimensions than by the hard science issues at their core. Fixing climate change, poverty, or even global financial regulation is not merely a problem of finding the correct solution to a thorny technical problem. These big issues are big because they entail questions of philosophy, ideology, justice, the proper form of society, and even culture. The underlying science is almost trivial compared to the value questions at stake.³ Here, again, we find that the study of liberal arts and humanities prepares a student far better to come to grips with the thorny issues at hand than, say, one prerequisite bioethics course for a pre-med major. Do we really want to turn the keys to our global future over to a bunch of narrowly-educated, really smart, culturally and historically naive technocrats? I sure don’t. Give me someone who has read Herodotus, analyzed Shakespeare, or argued over Rawls instead.

Lastly, there is the larger issue that, for all their power and demonstrable success, science and technology simply do not, cannot, will not address a host of questions and problems which are natural to the human condition. Here is Richard Feynman:

The next reason that you might think you do not understand what I am telling you is, while I am describing to you how Nature works, you won’t understand why Nature works that way. But you see, nobody understands that. I can’t explain why Nature behaves in this peculiar way.⁴

But this is simply not good enough. It may be futile, unscientific, even a cognitive mistake to ask big questions about the nature of reality (the “whys”), the proper form of relations to other human beings in society, our rights and duties to ourselves and others, and the very reasons for belief in our own knowledge (including, of course, science itself), but it is natural and ineluctable. Science will never address these questions. It doesn’t have the tools. Art, social science, literature, cultural studies, history, psychology, and soft sciences like economics do. For this reason alone we cannot, must not, will not abandon them.

To do so would be to forswear the very nature of what it means to be human.

The verifiability, the falsifiability of the sciences, their triumphant progress from hypothesis to application, constitute the prestige and the increasing domination they exercise in our culture. But in another sense, these also make up their sovereign triviality. Science cannot give an answer to the quintessential questions which possess or ought to possess the human spirit. Wittgenstein noted that point insistently. It can only deny their legitimacy. To inquire about the nanosecond prior to the Big Bang is, we are didactically assured, an absurdity. Yet we are so created that we do inquire, and may find St. Augustine’s conjecture far more persuasive than that of string-theory.⁵

* * *

I suspect Harvard’s Philosophy Department will be able to order that new laser printer next year, after all.

Related reading:
Alex Tabarrok, College has been oversold (Marginal Revolution, November 2, 2011)
First, Let’s Shoot All the Philosophers (April 22 2011)
Mary Crane and Thomas Chiles, Why the Liberal Arts Need the Sciences (and Vice Versa) (The Chronicle, November 13, 2011)
Why we subsidise arts majors (The Economist, November 3, 2011)
Eugene Wigner, “The Unreasonable Effectiveness of Mathematics in the Natural Sciences” (February 1960; accessed November 19, 2011)

¹ A sample which I freely acknowledge, for the benefit of my more scientifically inclined friends, to be neither comprehensive nor statistically significant.
² I speak, naturally, of the best of liberal arts education. Expecting a specialist in 15th Century Catalan poetry to be able to make such judgments is heroic, at the least (but perhaps not impossible, even then). But there are many disciplines under the rubric of the humanities which teach such skills. I do not wish to oversell this point, but it is clear—at least to me—that in an age of increasing specialization, someone should be paying attention to the forest.
³ If only, we presume, because it may admit of a clear solution we all agree to. Questions of value do not.
⁴ Richard P. Feynman, QED: The Strange Theory of Light and Matter, Princeton, New Jersey, 1985, p. 10.
⁵ George Steiner, “Ten (Possible) Reasons for the Sadness of Thought”, Salmagundi, Nos. 146, Spring 2005, pp. 3–32.

© 2011 The Epicurean Dealmaker. All rights reserved.

Known Unknowns

noreply@blogger.com (The Epicurean Dealmaker) — Mon, 07 Nov 2011 00:13:00 +0000

[Edward Ferrars and Elinor Dashwood are baiting Margaret Dashwood, who is hiding]

Edward: “Oh... Miss Dashwood. Forgive me. Do you by any chance have such a thing as a reliable atlas?”
Elinor: “I believe so.”
Edward: “Excellent. I wish to check the position of the Nile. My sister tells me it is in South America.”
Margaret: [out of sight; laughs]
Elinor: “Oh. No. No, um... she’s quite wrong. Um... for I believe it is in Belgium.”
Edward: “Belgium? Surely not. I... I think you must be thinking of the Volga.”
Margaret: [still out of sight; appalled] “The Volga?!”
Elinor: “Of course, the Volga. Which, as you know, starts in...”
Edward: “Vladivostock, and ends in...”
Elinor: “Wimbledon.”
Edward: “Precisely. Where the coffee beans come from.”
Margaret: [revealing herself] “Ah! The source of the Nile is in Abyssinia!”
Edward: “Is it? How interesting.”

— Sense and Sensibility (1995)

It is a heartening feature of the internet that one can often determine the truth about a subject by asking for the input and advice of experts, who upon application will usually contribute their knowledge freely. In my experience, it is an even more effective method to adopt a strong and firmly argued position upon a topic you know very little about. This will flush out even more experts, who will dismantle your faulty reasoning and expose your flimsy command of the facts with fierce glee or kind patience, depending on how charitably they view your ignorance and presumption.

My recent post on the current state of counterparty credit risk in the global financial system has already elicited two excellent reponses, and I am reliably assured that more are coming. The first of these was submitted to me by email, by a mysterious personage (let us call him or her “X”) who appears to be even more skittish about his or her real identity than Yours Truly, which is saying something. X’s first messages to me assumed a higher level of knowledge on my part than I possess, and X declined to let me disseminate his or her thoughts for reasons of security. Fortunately, after X read my babbling here and discovered exactly how ignorant I am about the day-to-day finance and operations of large trading banks, he or she took pity on me and sent new material fit for publication.

I now quote M/Mme/Mlle X at length, for your education as well:

Let’s look at the example of Bank A hedging some exposure by trading with Bank B. Let’s say

(1) Bank A has bought $100mm of CDS from Bank B,
(2) The CDS is currently worth 65 points (i.e. the $100mm notional contract is worth $65mm),
(3) Bank B has posted $60mm of collateral to Bank A.

What is Bank A’s direct exposure to Bank B? I would argue that the correct number is $5mm. If Bank B were to default and have 0 recovery, Bank A would post an immediate loss of $5mm, since Bank A already has the $60mm in collateral.

The point is that direct counterparty risk only exists on the uncollateralized portion of any exposure. One term for this is “gap risk.” This is relevant because in your example, Bank A would not try to hedge out its exposure to Bank B by buying protection on Bank B from Bank C. Almost all of Bank A’s exposure to Bank B is already covered by collateral. As for the remaining part, generally the amount of uncollateralized exposure that Bank A has to Bank B is not correlated to Bank B’s credit rating, especially if there are a large number of trades in multiple asset classes between the two banks. Bank A can’t know a priori what the uncollateralized amount will be if Bank B defaults; it’s just as likely that the CDS in the above example has moved from 60 points to 55 points and Bank A actually owes Bank B collateral. Also note that since this is essentially portfolio risk, doubling the number of trades with Bank B doesn’t actually double the exposure, especially if (as is common) many of the new trades are offsetting in risk. There’s no gross buildup of residual risk; this just boils down to net risk against the counterparty.

Why was AIG different? The above is a fairly accurate stylized approximation of what happens for relatively liquid CDS (which do increasingly go through central clearinghouses anyway). Something like a corporate or sovereign CDS is a distinct product that trades and has an observable market price. In the AIG case, most of AIG’s CDS exposure came from much more bespoke deals on structured products. A typical AIG CDS contract might be on some particular complex mortgage product, for which the only CDS trade was the one in which AIG wrote the protection. It has no observable market price and has to be priced using model assumptions on the underlying. This contrasts with e.g. sovereign CDS, where a price can be observed in the market and multiple trades happen on the same CDS; i.e. where there does in fact exist an observable market price.

Why is this relevant? In the above example, we assume that banks A and B agree on the contract’s valuation. If instead Bank A believes the contract is worth $65mm but Bank B only believes the contract is worth $30mm and has only posted that much collateral, then Bank A has $35mm of exposure to Bank B, which it will need to hedge accordingly. But the point is that this is a valuation issue; if the two banks actually agreed on the value of the contract, but Bank B simply refused to post collateral, then Bank B would be defaulting outright on its obligations, and would have its positions closed out accordingly, rather than have the counterparty risk just continue to exist.

The above discusses direct counterparty exposure in the sense of “losing money if my counterparty defaults.” There is of course further risk; if Bank B defaults, Bank A is left with that $100mm of risk that it previously didn’t have. But the risk here is actually a function of Bank B’s net exposure, not Bank A’s gross exposure. If, for example, Bank B had an offsetting contract for $90mm notional with Bank C, then after a default by Bank B, you would expect that Bank A and Bank C would offset their newly acquired risk against each other, such that e.g. Bank A only ends up with a $10mm change in risk, and Bank C ends up with no change in risk. This is pretty much what happened after Lehman defaulted. In fact there was a special trading session arranged for just that purpose, though most of the risk rebalancing actually happened in normal trading after the default.

I believe points (2) and (3) in your blog post boil down to concerns regarding net risk. I agree that large concentrations of net exposure would be a cause for concern, more so in illiquid positions but even to some extent in liquid ones. One way to get more comfortable with this in CDS space is just to look at the DTCC net notional numbers. By definition no entity’s net position can exceed the total net position. This ends up giving you a cap on how bad things can be; of course not ideal, but maybe less bad than you would initially think.

* *One more thing—and you can share this too as long as it’s not attributed.

The “margin call contagion” scenario you propose is not representative of how banks operate. Just about everything in a bank’s portfolio will already be contributing to its funding. Bonds will be repoed out (i.e. for cash equal to the bond’s value, less a haircut), stock will be lent out, and collateral posted on derivative contracts will be rehypothecated.

It’s possible that e.g. repo haircuts will exceed the bid-offer on some instruments and selling a security might give me slightly more cash than repoing it, but the extra amount is small. In general the notion of “liquidating a valuable position for cash” doesn’t make sense for a bank. Of course this may be different for a buy-side firm, but it doesn’t make sense for a bank to sell a security for liquidity purposes when it’s already used to secure some cash. This is also less true for illiquid things that can’t be financed; it is however true for any collateralized derivative position due to rehypothecation.

Alles klar?

* * *

So, at the risk of having my mysterious interlocutor correct me once again, I will take the liberty of drawing a few conclusions.

First, I think X has substantially diminished my fears about investment banks being piles of counterparty credit kindling just one counterparty default away from causing massive systemic conflagration. The daily zero-limit, two-way settlement of collateral calls between large investment banks (now current practice among most large market participants, according to this BIS study) means that, except in very fast moving markets, one should expect that changes in net margin requirements triggered by changes in the value of underlying investment contracts should be reasonably well-reflected in the risk books of most major banks. Second, the fact that big trading banks settle margin exposure on a net portfolio basis—which, Harry Markowitz assures me, should net out to less than the simple addition of each individual exposure across large, multi-market and multi-instrument portfolios—gives me some comfort that whatever residual risks accumulate on bank balance sheets should not be extreme. Third, X’s assurance that investment banks prefer to use asset positions to fund their operations rather than sell them for cash in a market meltdown leads me to discount the risk of cross-market contagion and “death spirals” triggered by collapses in unrelated markets. All these points directly address the second concern I cited in my previous post.

However, if my concerns about the risk of market collapse inherent in the structure and operations of large trading banks have been partially assuaged, I remain less confident about systemic risk in general. In particular, I worry more about investment banks’ exposure to substantial net risks created by large hedge funds, other originating banks (e.g., Dexia), and non-bank participants (e.g., AIG Financial Products). If one is to believe X, this is where the major risks are created and packaged. If Bank A trades with Hedge Fund 1, which cannot meet its financial obligations and has no counterparty assets of its own to net against A, Bank A could still be seriously fucked if Hedge Fund 1 defaults. Especially if Hedge Fund 1’s default coincides, as it well might, with a substantial gapping out of risk exposure on the underlying trade with Bank A.

Assume, as I would certainly hope we can in today’s markets, that most investment banks aspire to pretty close to zero-net present value risk books across the firm. (This is the fundamental philosophical tenet of the Volcker Rule.) Then risks to the system will be created not by the banks at the center of the markets, but rather by the risk-takers (investors, hedge funds, etc.) at the edges. And, should you need reminding, risk-takers don’t hedge all their risks to zero. Duh.

I also worry that investment banks remain seriously exposed in illiquid, hard-to-value markets now and in the future. X him- or herself hints strongly that the nifty daisy chain of traditional bank risk mitigation can get dangerously frayed under such circumstances. Sovereign CDSs may be relatively transparent, given the monitoring and data publication of the DTCC, but this is not true in every market. In particular, I worry that the next dangerous net risk exposure will be created in one of those opaque, highly-illiquid, obscenely profitable new markets which Wall Street is so fond of creating. And if there is no central repositary of trade data in a particular security or derivative market, no standardization and reporting of net and gross positions, what is to prevent the rise of yet another bunch of idiots like AIGFP to create a huge net risk position of which their multiple, competing investment bank counterparties remain blissfully unaware?

Last, I retain a nagging worry about the sheer complexity of the balance sheets, risk books, and insanely complicated credit and financing plumbing upon which modern day investment banks rely. Long-time Readers will know I am no fan of complexity, because it introduces fragility and vulnerability into any system. X and his peers may have designed a beautifully functional risk transmission system for their employers, but what happens if one of the pipes clogs or breaks, due to human error or unforseen complications? (How likely are those, I ask you? Yeah.) I have every faith that the clever gnomes of Wall Street can figure almost anything out, if you give them enough time. The problem is, that when the shit hits the fan at an investment bank, your clients are sucking funds out at a blistering pace, and the ratings agencies and your shareholders are in a desperate race to write you off forever, you have almost no time at all.

© 2011 The Epicurean Dealmaker. All rights reserved.

Methinks Thou Dost Protest Too Much

noreply@blogger.com (The Epicurean Dealmaker) — Sat, 05 Nov 2011 22:20:00 +0000

Any sufficiently advanced technology is indistinguishable from magic.

— Arthur C. Clarke

Attentive Readers will realize that I have used my durable and insightful epigraph before, specifically in a post which defended my industry against accusations of malfeasance arising from the common tendency of merchants in any economy reliant upon buying and selling to conceal the true costs and profits embedded in their activities. It was my contention then and is now that no law, human or otherwise, compels a vendor to offer buyers of its wares the “best price”—whatever that may be—or, indeed, prevents it from doing what profit-maximizing enterprises are commonly presumed to do: maximize profits. As long as said vendor is not selling faulty merchandise to inappropriate customers in a fraudulent manner, we should not expect to know nor require it to reveal all of its secrets.

This, however, is not that post.

For those of you with half a brain will (or should) realize that my idyllic little précis of laissez-faire capitalism skips lightly over two critical assumptions: that 1) all this happy buying and selling take place in reasonably competitive markets, where other vendors compete to offer the same good or reasonable substitutes therefor, and 2) the manufacture and sale of these goods does not impose intolerably noxious externalities on the society in which they are sold. The first of these can be seen as simply a special case of the latter, in which the externality which society should naturally seek to limit is economic rent-seeking in all its forms: monopoly, oligopoly, producer or factor cartels, preferential government regulation, etc. Of course, this tends to assume that the economy should be servant to society, rather than vice versa, which belief seems unhappily out of fashion nowadays.¹ Go ahead, call me a dreamer.²

A cynic might say that politics is nothing more than a neverending argument over the size and distribution of economic rents in society. But let us set that question aside for now. Instead, I would like to focus on other kinds of externalities: those corrosive and destructive injuries to society which are generated as ineluctable byproducts of the activity of certain unsavory economic actors, like arms dealers, child pornographers, and television reality show producers.

And investment banks.

* * *First, some history.

One of the principal functions of investment banks is the distribution of economic risk in society, from those who wish to sell it (and its associated productive return) to those who wish to buy. In the past, investment banks generally worked pretty well as conduits for risk, passing it from natural seller to natural buyer pretty effectively while skimming a small percentage off the top as recompense for their services. On the wholesale securities side of the house, they acted as large, temporary warehouses, buying and selling securities and derivatives on behalf of clients and maintaining minimal stocks in inventory to satisfy unforseen demand. It was a model which required little equity capital to support it, so investment banks levered up with short-term financing of their short-term assets and earned a nice return on the shareholder or partner equity they employed. Operating with so little equity entailed substantial risk, as a simple mistake or unexpected market shock could send the entire house of cards tumbling down. But because they tended to deal in liquid, easily marketed instruments, failed investment banks could be liquidated with relatively little disruption to their counterparties or the financial markets. Of course, the shareholders or equity partners got wiped out, but that was understood as part of the game. Live by the sword, die by the sword.

But then came the Great Moderation, and the industry changed. Investment banks merged and converted into universal banks, with commercial lending, mortgage businesses, and retail depositors, and they began swelling like mutant ticks on a hemophiliac dog. They began to warehouse more and more securities and derivatives to accommodate increased trading volumes on the market-making side. They began to warehouse more and more financial instruments for their own proprietary trading efforts. And they began to manufacture securities and derivatives, like mortgage-backed securities, credit default swaps, and other “structured products,” to meet investors’ insatiable demand for adequate returns in a seemingly riskless world. But as their balance sheets ballooned, these banks stuck with the tried and true risk management philosophy they had developed over decades as pure investment banks: mark your assets to market in real time, get out of losing positions early, and never hold risky assets in inventory without hedging them. Unfortunately, this is a strategy which depends at its core on operating in liquid, transparent markets, where prices are well known, trading volumes are robust, and hedging instruments are effective and liquid themselves. It also depends on a key principle which every trader knows: it doesn’t matter whether the markets are liquid or not if your position has become so large that you effectively are the market.

In addition, investment banks began to take on more and more counterparty risk as they waded deeper and deeper into such activities as leveraged lending, prime brokerage (lending and clearing for hedge fund clients), and derivatives and other structured products. And this was not the simple counterparty trading risk of old, where your primary worry was whether the party you traded with would deliver a security. It was counterparty credit risk, incurred as part of a trade in which your ultimate profit depended on your counterparty’s ability to satisfy its financial obligations, like repaying a loan, delivering an unencumbered security, or paying off a derivative. And let’s face it: investment banks have historically been lousy at credit analysis. Oh, sure, they’re fine when it’s short-term, secured lending, like a margin loan collateralized by liquid, easily-marketable securities with transparent market values. But lending money (or, what is the same thing, contracting for delivery of future economic value under certain circumstances) to counterparties subject to multiple financial risks and multiple financial obligations over a longer period of time? Not so much. And this is a big problem, because it seems that investment banks as a group have become their own biggest credit counterparties in many markets, particularly derivatives.

* * *

The problem is neatly illustrated by a recent Bloomberg article on the European sovereign credit default swap market:

Five banks—JPMorgan, Morgan Stanley, Goldman Sachs, Bank of America Corp. (BAC) and Citigroup Inc. (C)—write 97 percent of all credit-default swaps in the U.S., according to the Office of the Comptroller of the Currency. The five firms had total net exposure of $45 billion to the debt of Greece, Portugal, Ireland, Spain and Italy, according to disclosures the companies made at the end of the third quarter. Spokesmen for the five banks declined to comment for this story.

While the lenders say in their public disclosures they have so-called master netting agreements with counterparties on the CDS they buy and sell, they don’t identify those counterparties. About 74 percent of CDS trading takes place among 20 dealer- banks worldwide, including the five U.S. lenders, according to data from Depository Trust & Clearing Corp., which runs a central registry for over-the-counter derivatives.

Gross exposures are many multiples higher, of course, but the banks like to advertise their net exposures instead. The problem is that net exposures are not the clean, unassuming things a layperson might think they are. Take the following scenario: Bank A sells a $100 million credit default swap on Underlying Company or Country X to Hedge Fund 1. Then, in order to hedge itself, it buys an identical $100 million CDS on X from Bank B. Bank A has completely eliminated its exposure to X and can sail off into the sunset, happily counting the money it made in spread between the two transactions, right? Wrong. Bank A has not eliminated its risk exposure at all, it has merely introduced a credit risk exposure to Bank B, which is now on the hook to pay off the CDS if X craters. But what if B craters? Bank A is still on the hook, and now it is completely naked short a $100 million CDS. Now Bank A could try to protect itself against Bank B’s default by buying a CDS on Bank B from Bank C or Hedge Fund 2, but I think you must begin to see that that merely introduces a credit exposure to Bank C or Fund 2. Of course in real life all these counterparties try to ameliorate this exposure by requiring frequently refreshed margin collateral on these trades, with the objective that any party’s true risk exposure at any point in time is simply the difference between the value of the collateral held (usually cash) and the net cost to replace the instrument in question.

The challenge to global financial stability posed by investment banks conducting these activities is threefold, in my humble opinion. First, the daisy chain of trades illustrated above clearly demonstrates that investment banks never completely eliminate the residual risk involved in buying and selling investment contracts like CDSs and other derivatives. There will always be some risk attendant on any transaction which has not been completely immunized (like, e.g., Bank A buying an offsetting CDS from Hedge Fund 1, which would have the effect of cancelling the original trade), whether this is direct credit exposure to your counterparty or basis risk introduced by trying to hedge counterparty credit risk indirectly, like via short-selling its stock. Each such trade adds residual risk to the bank’s balance sheet and, given the tremendous aggregate volume of gross derivative trades investment banks do, these residual risks can accumulate to a very large and scary extent.

Second, because most big banks have overall margin agreements (Credit Support Annexes) in place with each other that aggregate offsetting daily margin requirements across all trades outstanding between the firms, the collateral protection mechanism itself can trigger contagion both within and across tightly linked firms. A bank or large hedge fund faced with a substantial margin call in one market or security might liquidate positions in other, more liquid securities in order to meet its obligations. If substantial enough, this can cascade through the markets and the trading books of interlinked investment banks, causing broader market sell-offs and further associated margin calls. This sensitivity is exacerbated by the highly leveraged financial profiles of most major financial market participants, especially the large trading banks and derivatives dealers.

Third, the ineluctably bilateral nature of many of these structured products and derivatives means that, no matter how careful and conservative any one investment bank is in structuring and managing its risk profile, nobody can be assured they are not transacting with another AIG Financial Products or, less dramatically, that systemically dangerous net exposures are not accumulating in disturbing quarters. The chief reasons that AIGFP’s collapse exacerbated the financial crisis were because it did not post collateral (due to its AAA credit rating), it transacted in difficult-to-value, illiquid markets, and it accumulated huge net exposure to mortgage-backed securities. And yet investment banks and others gleefully piled into counterparty credit exposure with AIGFP (the “dumb money”) until it cried uncle. Wall Street piled into copycat trades and lending relationships with Long-Term Capital Management, too, in a 1998 dress rehearsal for 2008’s systemic collapse. The very nature of secretive, cutthroat competition in my industry means that none of us want to share information that might reveal the existence of unsafe concentrations of credit risk in the system.³ How else can one explain why French-Belgian bank Dexia was able to write so many interest rate swaps that it required a government margin call bailout to the tune of $22 billion? Last month.

* * *

The practice of counterparty risk management on Wall Street has improved mightily since the Panic of 2008. Given that disaster, it damn well better have. But given the nature of massively connected, highly leveraged investment banks acting as conduits and collectors of the risk of the financial system, and their historical blindness to risks like counterparty exposure and risk concentration which were the very risks which nearly killed them (and us), I am loathe to take them entirely at their word that everything is hunky-dory now. Short of requiring all derivatives and structured products to be cleared through global exchanges (with associated net position limits and centralized margin posting) and sharply limiting overall financial leverage at trading banks, I do not see a failsafe solution to this conundrum. Investment banks are bred in the bone to be highly competitive and take substantial risks. Their competitive risk taking added materially to the accumulation of dangerous stresses and vulnerabilities preceding the crisis, and there is no reason to believe it will not do so again.

I would be delighted to be proved wrong about this by those who know much more about the plumbing of the financial system than I do.⁴ What is to prevent the occurrence of another AIG Financial Products? How can existing system controls prevent or dampen the cascade of credit failures through the system? Are potential leverage-induced death spirals limited to markets with illiquid, opaquely valued securities? If so, what prevents them from spilling over via contagion into other markets? What is to prevent a major securities or derivatives market meltdown from forcing another massive government bailout?

And if you are brave, knowledgeable, and/or foolish enough to try to answer these questions, please keep in mind the admonition of another very clever man whom few now trust:

There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don't know we don't know.

A wise man learns to plan for all three.

Related reading:
Committee on the Global Financial System, The role of margin requirements and haircuts in procyclicality (BIS CGFS Papers No. 36, March 2010)
Selling More CDS on Europe Debt Raises Risk for U.S. Banks (Bloomberg, November 1, 2011)

An early response:
Brandon Adams, Response for @Epicurean Deal (November 5, 2011)

¹ An economy is simply the set of organizing principles and rules which a society establishes to allocate and employ resources for the benefit of its members. How these rules are established and maintained is politics. To assert otherwise, or claim as some do that society and politics have no proper claim on the organization or maintenance of economic activity (e.g., via regulation or taxation), is the height of folly or disingenuousness.
² Those among you who cannot comprehend this concept and who would prefer to call me much less flattering names than “dreamer” are welcome to stock up on canned peaches and armor-piercing ammunition and join your fellow nutcases in Galt’s Gulch. The rest of us will come annihilate you when we can spare a moment. (Or just let you starve to death.)
³ For example, my best and most comprehensive source to-date for understanding the intricacies of the issues under discussion would not allow me to share them directly, in part because (s)he believed some of the generic information (s)he provided could provide a competitive advantage. And you people think I’m secretive.
⁴ All reasonable, informed, and specific responses are heartily welcome. I may publish or link to the most informative and interesting of these here. Please direct your responses to the email address found on this site, or notify me on Twitter (@EpicureanDeal) or by email if you have published it on another site. Please indicate if you would prefer no attribution.

© 2011 The Epicurean Dealmaker. All rights reserved.

Tort Reform

noreply@blogger.com (The Epicurean Dealmaker) — Fri, 04 Nov 2011 13:30:00 +0000

Overheard this morning at breakfast:

Lawyer #1: “Being a litigator is like cleaning the Augean Stables: it’s not particularly pleasant work, but you know you’ll always have a job.”

Lawyer #2: “That’s nothing. You should try representing investment bankers. It’s like being a streetsweeper in the Rose Parade: you have to deal with a neverending parade of horses’ asses, and you’re always cleaning up their shit.”

I love lawyer jokes. Especially when they’re told by lawyers.

Happy Friday.

© 2011 The Epicurean Dealmaker. All rights reserved.

She Blinded Me with Science

noreply@blogger.com (The Epicurean Dealmaker) — Sat, 29 Oct 2011 21:35:00 +0000

Science has not changed the laws of social growth or betterment. Science has not changed the nature of society, has not made history a whit easier to understand, or human nature a whit easier to reform. It has won for us a great liberty in the physical world, a liberty from superstitious fear and from disease, a freedom to use nature as a familiar servant; but it has not freed us from ourselves. It has not purged us of passion or disposed us to virtue. It has not made us less covetous or less ambitious or less self-indulgent. On the contrary, it may be suspected of having enhanced our passions by making wealth so quick to come, and so fickle to stay.

— Woodrow Wilson, A Commemorative Address, October 21, 1896

No matter what technology and science bring us, the dystopias of our future will always be of our very own, all-too-human design.

© 2011 The Epicurean Dealmaker. All rights reserved.

You’re Doing It Wrong

noreply@blogger.com (The Epicurean Dealmaker) — Sun, 23 Oct 2011 02:35:00 +0000

And he sampled the time-winds, sensing the turmoil, the storm nexus that now focused on this moment place. Even the faint gaps were closed now. Here was the unborn jihad, he knew. Here was the race consciousness that he had known once as his own terrible purpose. Here was reason enough for a Kwisatz Haderach or a Lisan al-Gaib or even the halting schemes of the Bene Gesserit. The race of humans had felt its own dormancy, sensed itself grown stale and knew now only the need to experience turmoil in which the genes would mingle and the strong new mixtures survive. All humans were alive as an unconscious single organism in this moment, experiencing a kind of sexual heat that could override any barrier.

— Frank Herbert, Dune

There is something deeply wrong with this country, O Dearly Beloved.

We seem to have painted ourselves into a corner from which we cannot escape. Grass roots movements as diverse as the Tea Party and Occupy Wall Street implicitly recognize this fact and have sprung up in response to it. People from a broad spectrum of Americans less committed, strident, and/or crazy than these activists have shown themselves to be largely sympathetic to their discontent. Depending on where you stand, and which hobby horse you happen to be riding at the moment, our predicament can appear in any number of guises: corrupt crony capitalism, grossly overbearing and inefficient government, a broken financial system deeply riddled with self-interest, or a society-wide breakdown of personal responsibility and uprightness.¹ Our so-called leaders—the very men and women we elected to get us out of this mess—cannot seem to tie their own shoes, much less offer a solution or even a direction in which to begin marching. Politicians are the only group of individuals more despised and less respected than investment bankers nowadays. Believe you me, as one of the latter, I can attest that that is a pretty damning indictment.

A common feature of many of our ills is the unmanageable size and complexity of our institutions and practices. This is certainly true of the government itself, our regulatory and tax systems, and our financial system. Part of this problem—size—may be an ineluctable outgrowth of the sheer mass of our nation and economy. One can certainly argue that size itself can lead to myriad ills. One can credibly entertain the notion that perhaps governing over 300 million people and managing a $14 trillion economy may be beyond the collective ability of any group of people, however intelligent or dedicated. Size certainly seems to have flummoxed the captains of my industry and their regulators in the most recent crisis.

But the bigger culprit, in my opinion, is complexity. Complexity makes things more difficult to manage. Complexity imposes substantial extrinsic costs, which must be expended simply to deal with complexity itself, apart from any underlying issues at hand. Complexity increases uncertainty, introduces distortions, and encourages mistakes. Want examples? Just think of the tax code, or the current state of the global financial system.

And yet we cannot seem to hit the rewind button on complexity. The latest example of this is the appalling complexification that the Volcker Rule—which was included in the Dodd-Frank financial reform act in order to prevent risky proprietary trading by government-backed depositary institutions—has undergone at the hands of those drafting the final regulations. The Beltway rulemaking sausage factory has turned what was a three-page initial proposal and a ten-page section in Dodd-Frank into a 300-page monster. A monster which, by all accounts, nobody loves.

Now, without a doubt a substantial portion of blame for this complexification can be laid squarely at the feet of industry lobbyists and banks themselves. They were the ones who lobbied so expensively and extensively for exemptions and extensions. They were the ones who no doubt insisted that the simple premise of the Volcker Rule was too simplistic to impose on a complex, interconnected industry without causing unacceptably expensive and potentially dangerous disruptions to established business practices.² I’m sure they offered all sorts of eminently reasonable objections to straightforward implementation of a separation between proprietary trading and depositary lending, while simultaneously missing or pretending not to understand that THAT IS THE VOLCKER RULE’S ENTIRE FUCKING POINT. That these dickwads and their hired guns were able to impose their will to neuter this piece of legislation you may credit to another virulent contagion in our polity: the pervasive and poisonous influence of corporate and individual money on politics and regulation.^{3, 4}

* * *

But the more general contributor to this legislative abortion is a structural one. Too many (all?) of the people writing these rules—both on the regulatory side and the industry itself—are lawyers. And lawyers have strong professional and cognitive biases against simplicity when drafting rules, laws, contracts, or indeed any sort of document designed to govern behavior. In all such situations, it is lawyers’ job, objective, and desire to minimize interpretation. They do this because they want to forestall future disputes and potentially expensive litigation by exhaustively codifying behavioral rules and spelling them out under every conceivable circumstance. Since when have you not seen a lawyer sorely tempted to insert a “provided, however” phrase into the simplest contract? Yeah, me neither.

A charitable reader like yourself might understand this impulse as a natural outgrowth of the pervasively litigious culture in the United States. For whatever reason, this tendency to sue first and ask questions later has led to a preponderance of rule-based, as opposed to principle-based regulation in this country. Nevertheless, codifying a principle as clear and straightforward as the Volcker Rule into a 300-page cookbook of recipes for what is and is not allowed in the financial sector is a wrongheaded exercise in futility. For one thing, exactly no-one can possibly anticipate how the financial markets and their constituent banks will change over the forseeable future. The global financial system is just too dynamic, and the likelihood that a piece of regulation penned in 2011 will be able to effectively anticipate and regulate financial market developments over the next several years is simply ludicrous. Investment banks themselves don’t know what kind of opportunities and threats they will face—and hence what they’re actually going to be doing—next quarter, much less in 2012 or 2015. How can we expect a static document drafted by a bunch of underpaid, cover-your-ass government lawyers who couldn’t recognize a proprietary trading desk if they were sitting at it to do so?

Because of this, regulators must have the ability to flexibly interpret and respond to changing conditions in the financial markets and the businesses of their regulatees.⁵ The relentless, rapid evolution of finance requires that financial regulation be principle-based, not rule-based. Reformed quant Emanuel Derman makes the case persuasively that we cannot understand financial markets using rigidly codified models. If that is true, how, then, can we ever hope to regulate them with a framework based on rigid, over-codified rules?

No points for guessing: we can’t.

* * *

So what does that mean for the Volcker Rule and financial reform in general? Well, one might argue that the best solution is to scrap that overlawyered piece of toilet paper and go back to the author of the eponymous rule’s own suggestion:

“I’d write a much simpler bill. I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance. And I’d have strong regulators. If the banks didn’t comply with the spirit of the bill, they’d go after them.”

Of course, this would be principle-based regulation. As Mr. Volcker points out, such a regulatory regime would require strong and well-informed regulators. I have made the same point, too many times to link to here, over and over in the past. Professor Derman is with me too. You would want ex-bankers, experienced in sales, trading, structured finance, and derivatives, who would work closely with regulated banks to monitor, understand, and control the changing nature of risks, activities, and opportunities in the markets. You would create performance incentives which completely insulate them from the results of their regulatees, and you would impose strict prohibitions on them returning to the industry before their active market and industry knowledge has gone stale.

Such regulation would demand close, realtime cooperation and consultation between regulators and industry participants. But if it is done properly, it should work out to everyone’s benefit. Regulators would get realtime information on risk exposures and market practices from their regulatees, and regulatees would receive realtime feedback and guidance from regulators on overall market developments and trends in risk management. Done properly, this model would not stifle innovation or profit-making. It would enhance it, while simultaneously reducing systemic risk and giving regulators early warning of developing threats to global financial security.

* * *

The Dodd-Frank legislation at over 2,000 pages is an abortion. The Volcker Rule at 300 pages is an abortion. They cannot succeed. If we cannot empower intelligent, experienced regulators to monitor and control the wholesale financial system using heuristic principles, we are fucked. Under the current financial regulatory system, and its proposed rules, we are all fucked. I will leave it to my Loyal and Long-Suffering Readers to decide whether that is a state of affairs which can be corrected. I suspect these pearls will be trampled like all the others into the muck of the pig wallow. Only time will tell.

In the meantime, we need to reinvent our rulemaking processes. Currently we make laws and regulations like oysters make pearls, except instead of starting with a tiny grain of sand and covering it with precious nacre, we start with a tiny pearl of sensible principles and cover it with layer upon layer of sand, grit, and detritus. This makes for ugly pearls, and lousy legislation.

When are we going to wake up?

Related reading:
Paul Kingsnorth, This economic collapse is a ‘crisis of bigness’ (The Guardian, September 25, 2011)
Grains of Sand (August 10, 2007)
James Stewart, Volcker Rule, Once Simple, Now Boggles (The New York Times, October 21, 2011)
Emanuel Derman, Maybe markets need more principles and less regulation (Reuters, October 21, 2011)

¹ For the avoidance of doubt, just in case you do care, I believe all of these things to be true. In my opinion, we are in deep doo-doo, and I see no-one on the horizon with a shovel.
² The premise behind these shenanigans is faulty. It is not the obligation of regulators to adapt, weaken, and modify regulations to minimize disruption to regulatees’ current business practices. It is the obligation of regulatees to modify their fucking business practices to comply with regulation. Jesus.
³ There is a part of me that hopes the Volcker Rule is implemented in its currently bastardized form so mega-banks will be forced to expend ridiculous amounts of shareholder money and management attention complying with the Frankenstein’s monster they have helped create. Karma can be a bitch.
⁴ As an aside, SCOTUS’s decision in Citizens United was an abortion of American jurisprudence. Just sayin’.
⁵ My focus throughout this piece is on regulation of the wholesale financial sector; that is, investment banks, commercial banks, and other entities which provide services to corporations, institutional investors, hedge funds, and other such non-retail customers. I have nothing to say about retail financial regulation, since that is neither my area of expertise nor my day-to-day concern. Perhaps more rule-based regulation makes sense for consumer finance, since I suspect that field is less changeable and dynamic than the wholesale sector. But I defer to others with better knowledge on that topic.

© 2011 The Epicurean Dealmaker. All rights reserved.

The Land of the Free

noreply@blogger.com (The Epicurean Dealmaker) — Thu, 20 Oct 2011 02:54:00 +0000

“At pet stores in Detroit, you can buy
frozen rats
for seventy-five cents apiece, to feed
your pet boa constrictor”
back home in Grosse Pointe,
or in Grosse Pointe Park,

while the free nation of rats
in Detroit emerges
from alleys behind pet shops, from cellars
and junked cars, and gathers
to flow at twilight
like a river the color of pavement,

and crawls over bedrooms and groceries
and through broken
school windows to eat the crayon
from drawings of rats—
and no one in Detroit understands
how rats are delicious in Dearborn.

If only we could communicate, if only
the boa constrictors of Southfield
would slither down I-94,
turn north on the Lodge Expressway,
and head for Eighth Street, to eat
out for a change. Instead, tomorrow,

a man from Birmingham enters
a pet shop in Detroit
to buy a frozen German shepherd
for six dollars and fifty cents
to feed his pet cheetah,
guarding the compound at home;

and a woman from Bloomfield Hills,
with a refrigerated Buick
wagon, buys
a frozen police department Morgan
for thirty-seven dollars
for her daughter who loves horses.

Oh, they arrive all day, in their
locked cars, buying
schoolyards, bridges, buses,
churches, and Ethnic Festivals;
they buy a frozen Texaco station
for eighty-four dollars and fifty cents

to feed to an imported London taxi
in Huntington Woods;
they buy Tiger Stadium,
frozen, to feed to the Little League
in Grosse Ile;
they buy J.L. Hudson’s, the Fischer Building,

the Chrysler Freeway, the Detroit Institute
of the Arts, Greektown,
Cobo Hall, and the Tri-City
Bucks Roller Derby
Team. They bring everything home,
frozen solid

as pig iron, to the six-car garages
of Harper Woods, Grosse Pointe Woods,
Farmington, Grosse Pointe
Farms, Troy, and Grosse Arbor—
and they ingest
everything, and fall asleep, and lie

coiled in the sun, while the city
thaws in the stomach and slides
to the small intestine, where enzymes
break down molecules of protein
to amino acids, which enter
the cold bloodstream.

— Donald Hall, Poem With One Fact¹

* * *“What we have here, is a failure to communicate.”

I wonder whether Dearborn will ever understand that rats are not delicious in Detroit.

¹ Donald Hall, The Town of Hill. David R. Godine, Boston, 1975, pp. 13–15.

© 2011 The Epicurean Dealmaker. All rights reserved.

If the Phone Don’t Ring, You’ll Know It’s Me

noreply@blogger.com (The Epicurean Dealmaker) — Sat, 01 Oct 2011 15:20:00 +0000

As a dashing, handsome, witty, and debonair man-about-town, you might well imagine, Dear Readers, that I receive copious quantities of correspondence begging a minute of my precious time to address some issue or other. Often, it is some tyro who has read my work here, soaking up the reflected glory and excitement of the world of high finance while simultaneously eliding the irony, sarcasm, and disgust which naturally comingle therein. Said tyro is almost always looking to “break into” my industry, after having read my semi-ironic paean to investment banking (but missing the irony) or talking with his shell-shocked peers who already cling tenuously to 100-hour-a-week waterboarding slots at überbanks.

Notwithstanding its own not-insignificant challenges and the social opprobrium currently attached to investment banking by society at large, it’s hard to blame the poor dears:

Unlike, say, 99.6% of all other jobs available to a wet-behind-the-ears idiot in proud possession of little more than an expensive college degree, becoming an investment banker fresh out of college is a huge rush. Depending on what role they perform, new entrants just weeks into the job can participate in billion dollar underwritings, multi-billion dollar mergers, complicated cross-border restructurings, or devilishly complex trading programs, all the while possessing a level of experience formally known in the industry as “jack shit.”

In what other industry, I ask you, can a 22-year-old who just stopped wetting the bed three weeks ago participate in a deal which runs for weeks on the cover of The Wall Street Journal or the Financial Times? To be sure, he is probably doing little more than making copies, getting coffee, and trying not to look as stupid and lost as he feels, but at least he is in the room. Contrast this, if you will, with a fresh McKinsey recruit tasked with interviewing shop floor supervisors to develop a human resources inventory for a ball bearing manufacturer in East Bumfuck, Illinois. Or a pre-law student who spends 80 hours a week in a windowless basement cross-checking sale-leaseback contracts for a patent dispute in Moldavia. On average, young investment bankers spend less time traveling that management consultants and more time sleeping than corporate attorneys. Plus, they get to tell their friends and family that they carried Bruce Wasserstein’s bags. What could be better?

Unfortunately, from their perspective, many of the youngsters who contact me fear they do not possess the “right” degree from the “right” school which they believe will magically open the secret door into this wonderland of fun. Often they have tried and failed to pursue the standard on-campus recruiting paths or have come up short with the fearsome Human Resources harridans who guard the gates to Analyst or Associate recruiting. And so they reach out to Yours Truly, pleading for fifteen minutes of my time on the telephone or in person to give them the key to investment banking Valhalla.

For the avoidance of doubt, and for the benefit of the 20 hapless supplicants feverishly typing emails to me in response to this post, let me make this perfectly clear:

No. Nope. Unh-unh. HELL NO.

I don’t do phone calls or meetings. Haven’t any of you seen Enemy of the State?

* * *

By the same token, it is a waste of electrons to send me your resumé. To whom would you suggest I send it? “Oh, uh, hi, Jerry at Goldman Sachs. I, uh, just happened to find this fascinating resumé lying on the fax machine. Would you mind taking a hard look at it? Wait. What do you mean? No, I don’t know anybody named ‘TED’. Why do you ask?” Consider my carefully defended pseudonymity an impermeable barrier to contact, referrals, or recommendations in the real world. Sorry, but that’s just the way it is.

However, as partial recompense for your pains, and to show I am not a completely heartless bastard, I am happy to share with you here the same advice I give aspiring applicants to my industry under my own identity.

First of all, having a degree in finance or economics from a top-ranked college or business school is not a sine qua non to get hired into investment banking. But I’ll not kid you: it helps. Especially now, when the industry is under severe pressure to retrench. Why? Because it acts as an easy screen for harried recruiters to winnow down the hundreds if not thousands of job applications they receive to a more manageable horde. Taken separately, a degree from a top school shows that other demanding institutions have deemed you worthy in the past, and a degree in finance, economics, or accounting shows you have an understanding of (and possibly a love for) the basic tools and concepts of our trade. Beyond that, they tell us almost nothing about whether you have the drive, passion, and capacity for our business. The only way we can find that out is by throwing you into the fire itself.

For I have seen dozens of top-ranked Ivy League graduates flame out (or worse, fizzle) over the years, mostly due to lack of energy, drive, or commitment to do what has to be done. Not because they weren’t smart enough; no, they were just too lazy or too entitled to get down in the mud and wrestle with the alligators, which is why we hire young cannon fodder like you in the first place. Survive the alligators, and you have a chance to rise into the haughty position of power, influence, and respect you feel you deserve. Don’t survive, and we’ll toss your mangled corpse out the back door onto a trash heap like a used Kleenex.

Did I mention investment bankers are heartless bastards?

* * *

What does it take to succeed in my business? You have to be really smart (don’t kid yourself on this one: it’s a high hurdle), determined, aggressive, and indefatigable. You have to be quick on your feet, too, because change is ever present in investment banking, and you have to be able to adapt to wildly different situations and volatile personalities. You have to learn how to work with financial statements, accounting concepts, and spreadsheets. You have to be good with people. You have to be a quick learner, because no school can teach you what you need to know and how to do it: investment banking is and always will be an apprenticeship business. And you have to (learn to) love the business. If you don’t, you’ll burn out: it’s just too hard and demanding.

Nowhere in that litany, you will notice, did I say you need a finance degree or an Ivy League diploma. Those help getting in the door, but they tell us little about whether you will be a good hire. So, what do you do if you don’t have the kind of credentials which almost guarantee you will get a first round interview? You have to be creative in your approach, flexible and clever in your campaign, and you have to convincingly demonstrate the traits of successful investment bankers I have enumerated above when you get in the door.

Reach out to people you know, ask for recommendations to senior bankers from your friends and family, request informational interviews with these bankers (but not unreliable, curmudgeonly pseudonymous bloggers), and go show them you have what it takes. Don’t give up. It will be very hard. But if you can get in the door, you will have proved to yourself and your employer that you have all the tools you need to make a positive impact.

And maybe one day, if you are smart, hard-working, and very, very lucky, you’ll be kicking some prissy Princeton prima donna the HR geeks sent you to interview out on his ass because you can’t trust him to bring back your coffee order from Starbucks correctly.

Good luck, campers.

* * *

A Hard Rain’s Gonna Fall

noreply@blogger.com (The Epicurean Dealmaker) — Sat, 01 Oct 2011 02:30:00 +0000

“Have you ever stood and stared at it? Marveled at its beauty, its genius? Billions of people just living out their lives. Oblivious.

“Did you know that the first Matrix was designed to be a perfect human world, where none suffered, where everyone would be happy? It was a disaster. No-one would accept the program, entire crops were lost. Some believed that we lacked the programming language to describe your perfect world, but I believe that, as a species, human beings define their reality through misery and suffering. The perfect world was a dream that your primitive cerebrum kept trying to wake up from. Which is why the Matrix was redesigned to this: the peak of your civilization. I say your civilization, because as soon as we started thinking for you it really became our civilization, which is of course what this is all about.

“Evolution, Morpheus, evolution. Like the dinosaur. Look out that window. You’ve had your time. The future is our world, Morpheus. The future is our time.”

— Agent Smith, The Matrix

Things must be getting pretty ugly on the trading floors of big investment banks worldwide, O Dearly Beloved. If you still have any friends or acquaintances desperately clinging to such formerly gainful employ, you would be kind to spare them a tear or a LinkedIn invitation or two. I am sure they would appreciate the gesture.

You wanna know how I know that? Well, if the constant drumbeat of articles trumpeting the death of proprietary trading and its enabler, mountains of cheap capital, weren’t enough, how else could one explain this?:

One of the mysteries of investment banking is why M&A is held in such awe. Advisory bankers swan around like they own the place. They have the nicest suits. The senior ones are also difficult to fire, insisting they nurture the crucial relationship with corporate clients (in spite of perhaps not having done a deal in years). M&A activity in 2011 could fall 5 per cent below last year’s volumes despite a strong start, according to Keefe, Bruyette & Woods. Against a backdrop of declining activity, there are three good reasons why M&A should be brought back to earth.

Or this?:

Meanwhile, [M&A] prima donnas take home bank. But do they make profits for their firms? Or is the big money in the deal add-ons, like providing financing to pay for takeovers? We’ll never know for sure, but our money is on the drones and not the guys in pinstripes.

In my day, we used to call such patently bought and paid-for hit pieces “advertorials.” I hope the FT’s Lex team and DealJournal’s writers got nice honoraria for their troubles, or at least a couple of beers or so. Because as reporting goes, both pieces are complete and utter bullshit.

* * *

Not that I disagree with most of the facts and assertions both articles present,¹ mind you. Mergers and acquisition revenues have always been volatile and highly cyclical; they are tightly tied to the business cycle and trends in financial markets. They are also without doubt tiny in relation to the enormous revenue from the sales and trading (capital markets) side of the house at integrated investment banks. This has been true for more than a decade, ever since the capital markets divisions of global investment banks looked at the tsunami of cheap liquidity flooding the world financial system and decided they would like a taste. No M&A or corporate finance banker in the business longer than six months would attempt to deny this. Why else do you think so many major integrated investment banks—the Great Vampire Squid preeminent among them—are run by short-sleeve-wearing, onion-cheeseburger-eating troglodytes from the trading floor?²

But given this very power and earning disparity between the advisory and capital markets sides of the business, why did the leading organs of financial journalism on both sides of the Atlantic feel compelled to chew up column inches with snarky attacks on M&A bankers? Why pick on the little kid? Whence also the frat bro sniping at “nice suits” and “pinstripes,” as if knowing how to knot a tie or deigning to wear nice clothes more than twice a year were somehow sins against “authenticity” or some such puerile bullshit? What’s the fucking point?

I’ll tell you what the fucking point is: everyone on the trading floor of every leading investment bank is about to get fucking fired.

* * *

Now of course that is untrue, and a gross exaggeration (although one my rough-hewn compatriots on the turret phones can appreciate). But it is no exaggeration to say that the capital markets gravy train of the past ten years or so is coming to a rapid, screechy, and highly painful end. The Volcker Rule, Basel III, and the re-emergence of actual, functioning risk management from the bowels of the Chinese opium den where it has been languishing for the last decade will see to that. Gone are the days of 60-to-1 leverage, compliant regulators, risk-loving shareholders, and politicians who could afford to turn a blind eye to an industry which used implicit government backstops as collateral in the global casino. This will put massive pressure on revenue, profits, and compensation in capital markets divisions everywhere. And if there’s one thing senior investment bank executives know how to do when faced with compensation pressure, it’s fire people. Lots of people.

The other thing senior managers know how to do is fight for a bigger share of the bonus pool, especially when said pool is shrinking faster than homeowners’ equity in Nevada. Hence the perennial resuscitation of tired old arguments and clichés about bankers on the advisory side of the house—that they are prissy peacocks who add no value and steal credit for revenues properly earned by sales and trading—in order to preserve one’s own subordinates’ share of the compensation pie. Of course, when sales and trading was demonstrably bringing in many multiples of the revenue that advisory was, capital markets executives had little need for such arguments. They could just point to their profit and loss statements and tell senior management how much they expected to keep. As far as they were concerned, the midgets in M&A could suck it. But now that the worm has turned, and steroid-fueled sales and trading profits from structured products and proprietary trading are evaporating in the noonday sun, capital markets managers have been reduced to jawboning and badmouthing their colleagues in the press.

So congratulations, Lex and DealJournal, you’ve just been reduced to shills for traders in their internal bonus discussions. You might want to check your sources’ business cards to see which division they work for. As if you don’t already know.

* * *

The other major criticism or insinuation our beloved fourth estate sock puppets parrot for their sales and trading overlords—that M&A and corporate finance bankers’ claim to add value via access to corporate clients is untrue—is no more than tendentious, uninformed bullshit. For one thing, the reason so many of us wear nice suits and ties is because we actually meet with real, live clients on frequent occasion. This is in strong contradistinction to most of the denizens of the trading floor, whose primary contact with people outside their own firm consists of punching a preprogrammed button on their turret phone and talking to their similarly Dockers™-clad counterpart over a Plantronics headset. Unlike the hedge fund and institutional investor counterparties investment bank traders deal with—who trade promiscuously with everybody on Wall Street and who don’t give a rat’s ass whether they like or even trust the trader in question, as long as he completes trades as he said he would—getting corporate clients to do transactions requires building trust and rapport over many years. This is absolutely the case in pure M&A, where no capital markets financing or derivative transactions are involved, but it is also true in more general corporate finance contexts.

I have stated time and time again that, notwithstanding the delusions of so many of my peers, there is no service or product on Wall Street which is not completely commoditized. This is true of M&A advice, but it is particularly true of any product or service flogged from a capital markets desk. Proprietary products can be and are reverse-engineered within weeks, if not days, and plain vanilla shit like high yield bonds, interest rate swaps, or initial public offerings are a dime a dozen. There is literally almost nothing Goldman Sachs can do that Morgan Stanley, JP Morgan, Bank of America, or even short-bus rider Citigroup can’t do equally as well.

Hence, Lex’s assertion,

Perhaps clients would buy other products because they are excellent in their own right and not because of an introduction from advisory.

is on its face ludicrous. First, because no bank has any monopoly on excellent products for any length of time. Second, because there is no-one on the capital markets floor of any big investment bank who has close, proprietary relationships with corporate issuers which would encourage said issuers to agree to do deals with him directly. That is not his job. It is the job of the corporate finance or advisory banker to make the introduction to the product guy. It is the product guy’s job to structure, issue, and sell the resulting product. They work together.

In a similar vein, Lex’s uncritically repeated assertion that some M&A “standalone cost-income ratios... can be as high as 400 per cent” is just dumb. If any coverage or advisory banker truly got paid four times the actual revenue he or she brought in, rather than getting fired on the spot, he or she must have some really indiscreet photos of the CEO with a well-oiled goat. Part of the advisory banker’s job—as opposed to, and often in addition to, pure M&A advice—is to give his or her client access to the entire range of products and services the bank offers. If that client transacts capital markets deals with the bank, the coverage officer who made the introduction deserves some of the credit (and pay). Saying otherwise is like saying a Boeing salesman doesn’t deserve to be compensated for selling planes because he doesn’t actually build them. That’s just stupid.

* * *

In any event, my entire industry faces a very painful restructuring as the high-octane profits of structured products, proprietary trading, and massive trading volumes driven by global uncertainty ineluctably dry up. In such an environment, where capital is no longer either cheap or plentiful, business lines which can make money using minimal capital necessarily acquire greater power and prominence. Given that pure M&A uses exactly no capital, it is only natural that M&A bankers will reacquire some of their old influence within investment banks. When financing is tight, it’s hard to argue with an infinite return on capital.³

Of course, I continue to maintain that integrated investment banks live or die by the inextricable cooperation of their advisory and capital markets arms. We are tied together at the hip, and that which hurts one of us will hurt the other, too. So I take no particular pleasure in noting the imminent demise of thousands of my capital markets brethren across the industry. I just take care to note that my fellow sentient programs and I expect a rather larger share of the pie than before.

¹ Chronologically, the Lex article appeared earlier, and it provides the meatier substance of the two. The DealJournal piece does little more than parrot Lex and toss in a few jejune Americanisms (“take home bank”) favored by the 20-something tyros who staff the nether regions of big banks, presumably for the benefit of native readers unfamiliar with language heard outside the lacrosse field. Not that I’m judging or anything.
² I kid, I kid. But, really, I have to get some digs in of my own, don’t I? You should know by now that I’m no saint.
³ It is also no matter of indifference in today's environment that when an M&A banker screws up or fails to close a deal, he loses only time and a potential fee. When a prop trader or structured products banker screws up, he can blow a hole in the side of his bank larger than all the revenues earned by all of his compatriots all year. And when a whole industry of capital markets bankers screw up, it can blow a trillion dollar hole in the side of the global economy. Or so I hear.

© 2011 The Epicurean Dealmaker. All rights reserved.

A Victim of Soycumstance

noreply@blogger.com (The Epicurean Dealmaker) — Sat, 24 Sep 2011 21:20:00 +0000

[The Stooges are about to attend a fancy ball]
Moe: “Now then, gentlemen, remember your etiquette.” [Gives both Larry and Curly a slap.]
Larry: “What’s that for?”
Curly: “We didn’t do nothin’!”
Moe: “That’s in case you do when I’m not around!”

— The Three Stooges

Bloomberg published a nice piece earlier this week which supports my long-held belief that the term “investment banking management”—like “military intelligence” or “legal ethics”—is, in the trenchant phrase of Raymond Chandler,¹ “an expression which contains an interior fallacy.” In other words, an oxymoron.

Authors Michael Moore and Max Abelson do a creditable job illustrating how the toxic relationship between Colm Kelleher and Paul Taubman, co-heads of Morgan Stanley’s Institutional Securities Group (corporate finance and M&A, plus capital markets)² is creating all sorts of fallout for that division. Kelleher is the hail-fellow-well-met Irish Oxford graduate who runs Morgan’s sales and trading operations, and Taubman is the weedy, quiet loner who leads the investment bankers. I have seen working relationships between similarly mismatched personalities work out very well over the course of my career, with complementary skill sets and different management styles combining synergistically to produce results beyond the capacity of either party alone. Of course, such success stories depend at their root upon the parties in question respecting each other’s different styles and abilities and working together explicitly for the greater good. This does not appear to be the case in this instance.

Interestingly enough, Morgan Stanley’s ISG seems to be turning out near-record results and taking market share, so a naive outsider might question whether its co-heads’ feud matters, or, what is more, might even be good for the division. Certainly this is what the Aspergers-addled technocrats who populate the executive ranks of most investment banks measure and value to the exclusion of all else, so I can understand how CEO James Gorman might consider his lieutenants’ squabbling an unimportant sideshow.

If so, he is dead wrong.

* * *

Put aside, for a moment, the not inconsiderable problem that the tension and infighting between Kelleher and Taubman is, sadly, the norm rather than the exception when it comes to interactions among senior executives at investment banks. This is much more than an issue of incompatible personalities. For one thing, investment bankers and traders who are hard-charging, capable, and, dare we say it, psychopathic enough to climb the slippery pole and get within reach of the top tend to have sharp elbows, short tempers, and little patience for those who oppose their wishes. Given furthermore that Taubman and Kelleher seem to have been put in implicit if not explicit competition for the top job, and the Bloomberg article indicates they both want it, such a set up would make it hard for Mother Teresa and her twin sister to get along.

Whatever its sources, the competition and bad blood at the top of their respective organizations cannot help but trickle down to Kelleher’s and Taubman’s subordinates. These will line up sensibly behind their leaders and take their tone of interaction with colleagues across the functional divide from the top, if only in the interest of self-preservation. This is Organizational Dynamics 101. The result will be inadequate communication, counterproductive political maneuvering, and willful lack of cooperation between investment banking and sales and trading at all levels. Traders will fall back into the venerable habit of regarding investment bankers as foppish, ineffectual parasites in suits, and investment bankers will resuscitate their ancient scorn for capital markets folk as barely literate, knuckle-dragging troglodytes. In addition to being unhelpful and untrue, such behavior never ends well.

For investment banks in general derive the greatest source of their power, value, and privileged position in the economy from the fact that they straddle the markets for capital, operating on both the supply and demand side. Investment banks serve the suppliers of capital—investors—by delivering new investment opportunities and products through underwriting new issues and originating new securities and by helping them reallocate their investment portfolios through making markets in securities and other financial instruments. This is done on the sales and trading, or capital markets, side of investment banks. Investment banks also serve the users of capital—corporations, governments, and the like—by selling their securities to investors and by helping them reallocate their business portfolios via mergers and acquisitions. This happens on the corporate finance and M&A, or investment banking, side of the same banks.

Each side of the bank derives a substantial part of its revenue, access, and value from the other side. Sales and trading and investment banking share information (subject to confidentiality restrictions), access to each other’s clients, and revenue from transactions arranged between them. Banks act as middlemen, and we make our daily bread by mediating transactions across the capital user–capital provider divide. This is core to what traditional investment banks do. It is a network business. Accordingly, anything which weakens the network—especially between capital markets and investment banking—seriously undermines the business.

I have sounded this warning before:

Notwithstanding what they like to tell you, investment bankers don’t really sell “ideas.” They sell connection, and access, and they are successful to the very extent they can maintain themselves in the flow of market information. Investment banks derive their market power and importance by maintaining dense and robust information networks across the numerous markets they participate in. This makes them better traders, better investors, and better advisors.

In the overall scheme of things, a successful bank should prefer to have strong networks, rather than strong bankers. Take a banker with excellent network connections out of his or her supporting environment, and he or she becomes dramatically less effective. Allow individual bankers to weaken the network by hoarding clients, refusing to communicate, or actively undermining their rivals within the firm, and you weaken the bank materially. Encourage the hiring and creation of “superstars,” and you shift power away from the bank into the hands of individual mercenaries. All of these things make an investment bank less valuable to its clients, as well.

I don’t care if Morgan Stanley’s investment bank had a blowout quarter. If Taubman and Kelleher are wasting time, energy, and opportunity pissing on each other’s shoes, they are fucking up. Morgan Stanley could do better.

* * *

Now I don’t mean to minimize the real structural conflicts between investment banking and sales and trading. They each serve different client bases with different needs and objectives. They each make money in different ways. The desires of their respective clients are rarely in sync, and sometimes the way each division makes money conflicts directly with the goals and profitability of the other. It is not so simple as one firm, one income statement.

Underwriting new securities is one area where corporate finance and capital markets cooperate directly, to source capital for issuers and sell securities to investors. But even there the alignment of interests is not complete. The corporate finance client wants to issue securities at as high a price as possible, and the capital markets clients want to buy low. This tension plays out daily in internal discussions between the bank’s departments, and believe you me it can get pretty heated on occasion. Market making is a capital markets business line independent of corporate finance, but it does have potentially positive (or negative) secondary effects on the latter, since a firm’s market position trading certain securities can affect whether bankers can win a particular piece of underwriting business or not. Be the number one trader of social networking stocks, for example, and your bank stands a good chance of leading Groupon’s IPO. Be number 15, and you can forget it. Corporate finance always wants sales and trading to make deep and active markets in certain areas, but capital markets often pushes back, because market making requires capital, and capital is expensive. The influence runs the other way, too: a bank which is active and successful in originating or underwriting securities in a particular market is far more likely to become the “axe” in that area. This drives greater sales and trading volume and, hence, greater capital markets profits. But if a bank has little track record issuing securities into a particular market, it becomes difficult for sales and trading to make money there independently.

You can see the potential for conflict even among pure agency business lines like underwriting and market making. This conflict is thrown in stark relief when an investment bank begins to assume a principal position in a particular trade. The example cited in the Bloomberg article is where Morgan Stanley’s capital markets group tries to sell derivatives in connection with a security underwriting, like interest rate or currency swaps on a bond issuance. But, as Bloomberg points out, while such a “deal can bring in significant trading revenue, it can also place the bank in the position of being a counterparty to a client it just advised.” Let me tell you something: as a corporate finance banker and advisor, this gives me the heebie-jeebies. I always worry my sales and trading guys are ripping my client off, and I shudder to think what would happen to the multi-million-dollar relationship I have carefully cultivated with my client over many years if things go pear-shaped. This is true of any transaction where an investment bank assumes the role of a principal—whether trading counterparty, lender, or direct investor. From a corporate finance banker’s perspective, the risk usually isn’t worth the potential gain, especially since all the profits from such proprietary trades seem to magically disappear into the capital markets budget before corporate finance gets its cut.

* * *

In fact, the organizational dynamic between a traditional investment bank’s sales and trading and investment banking divisions resembles nothing so much as an iterated prisoner’s dilemma. This is a game theoretic formulation of a situation in which two parties, who have some interests in common and some in conflict, must decide whether to cooperate or compete for desireable outcomes. Those readers among you who share little sympathy or liking for my profession will be delighted to learn that the traditional formulation used the example of two criminals:

Two men are arrested, but the police do not possess enough information for an arrest. Following the separation of the two men, the police offer both a similar deal—if one testifies against his partner (defects), and the other stays quiet (cooperates), the betrayer goes free and the cooperator receives the full one-year sentence. If both remain silent, both are sentenced to only one month in jail for a minor charge. If each ‘rats out’ the other, each receives a three-month sentence. Each prisoner must choose to either betray or remain silent; the decision of each is kept quiet. What should they do?

Sadly, perhaps, for those of you who would prefer all investment bankers to be thrown in jail, there is a fairly well-established solution to this dilemma, especially when it occurs over and over in an extended game of multiple rounds of unknown number. The best strategy appears to be a variation of “tit-for-tat,” in which a participant is nice, retaliatory, forgiving, and non-envious. I will leave it as an exercise for my Clever and Esteemed Readers to determine whether these behaviors strike you as consistent with the personality of your average investment banker.

In any event, the material point is that, like the traditional prisoner’s dilemma, the interaction between capital markets and corporate finance can, with proper focus and strategy, be elevated from the suboptimal, default outcome of mutual betrayal and non-cooperation into a stable, cooperative solution that benefits both parties. And if, in the case of Morgan Stanley (and investment banking generally), the participants are not wise, patient, or sensible enough to arrive at the best solution themselves, it is the job and obligation of senior management to drag them there kicking and screaming, or fire their sorry asses and promote somebody else.

Sounds to me like James Gorman needs to give a couple of guys a dope slap or two.

¹ Playback.
² Throughout, I employ industry-standard but often confusing terminology, in which “investment banking” = “corporate finance (and M&A)” and “capital markets” = “sales and trading.” Oh, and “investment bank” means the whole damn firm. Alles klar?

© 2011 The Epicurean Dealmaker. All rights reserved.

A Grave in the Clouds

noreply@blogger.com (The Epicurean Dealmaker) — Fri, 09 Sep 2011 19:25:00 +0000

In memoriam, September 11, 2001:

If thou didst ever hold me in thy heart
Absent thee from felicity awhile,
And in this harsh world draw thy breath in pain,
To tell my story.

— William Shakespeare, The Tragedy of Hamlet, Prince of Denmark

* * *

A Good Death

noreply@blogger.com (The Epicurean Dealmaker) — Sun, 04 Sep 2011 20:10:00 +0000

“Always after a defeat and a respite, the Shadow takes another shape and grows again.”
“I wish it need not have happened in my time,” said Frodo.
“So do I,” said Gandalf, “and so do all who live to see such times. But that is not for them to decide. All we have to decide is what to do with the time that is given us.”

— J.R.R. Tolkien, The Fellowship of the Ring

I was far away, across an ocean, on September 11, 2001. I could do nothing but look on in horror and pity as my adopted city and my old haunts burned and choked with the smell of crumbled buildings and smoldering flesh. My friends and acquaintances—some, former neighbors who lived within the topple radius of the towers in Battery Park City—all survived. A college classmate who worked above the 100th floor in one of the towers overslept that morning and never made it to work. They were lucky. They all have memories of those horrible days and weeks afterward, when they struggled to pull their lives together. Those who could, left the city. Some never returned.

In contrast, my memories of that day are remote and uninteresting. A client visit planned that morning was cancelled because the CFO got sick. My first inkling that something was happening came when a colleague walked into my office and told me Bloomberg was reporting a small plane had crashed into the World Trade Center. Later, I wandered down to the trading floor to watch the two towers—burning, but as yet still standing—smoke on the huge TV monitors. I listened in silence as my European colleagues talked about the tragedy in hushed, uncomprehending tones. I listened to them speculate how many hundreds had died, while keeping to myself the half-remembered knowledge that tens of thousands of people passed through those buildings and the surrounding office, transport, and shopping complex every day. I went home.

* * *

Later, of course, the stories and pictures trickled out. Of the many I read, one stuck with me: James Stewart's February 2002 profile of Rick Rescorla, the head of security for Morgan Stanley Dean Witter at the World Trade Center. Rick was the guy who led the evacuation of 2,700 MSDW employees out of the south tower, in defiance of initial Port Authority orders to stay put. Rick was the guy who cheered and cajoled his frightened colleagues down the stairs with a bullhorn, singing America the Beautiful and Cornish battle songs all the while. Rick was the guy who then turned around and, taking his deputies with him to check for stragglers and injured, went back up into the building.

“What’s really difficult for me is that I know he had a choice,” Susan says. “He chose to go back in there. I know he would never have left until everyone was safe, until his mission was accomplished. That was his nature. That was the man I loved. So I can understand why he went back. What I can’t understand is why I was left behind.”

Dan Hill says that Susan will understand someday, as he does. “What she doesn’t understand is that she knew him for four or five years. She knew a sixty-two-year-old man with cancer. I knew him as a hundred-and-eighty-pound, six-foot-one piece of human machinery that would not quit, that did not know defeat, that would not back off one inch. In the middle of the greatest battle of Vietnam, he was singing to the troops, saying we’re going to rip them a new asshole, when everyone else was worrying about dying. If he had come out of that building and someone died who he hadn’t tried to save, he would have had to commit suicide.

“I’ve tried to tell Susan this, in a way, but she’s not ready yet for the truth. In the next weeks or months, I’ll get her down here, and we’ll take a walk along the ocean, and I’ll explain these things. You see, for Rick Rescorla, this was a natural death. People like Rick, they don’t die old men. They aren’t destined for that and it isn’t right for them to do so. It just isn’t right, by God, for them to become feeble, old, and helpless sons of bitches. There are certain men born in this world, and they’re supposed to die setting an example for the rest of the weak bastards we’re surrounded with.”

I'd like to think Rick Rescorla died the way he would have chosen to die: moving forward, fulfilling his duty, trying to protect the people entrusted to his care. Surely, given his character, that must have been easier to confront than a long decline into sickness and debility. Of course, no-one wishes death on anyone, but it is a blessing to be offered a choice sometimes. Not all of us are offered a choice.

But all of us can choose how we confront it.

* * *

No matter how it comes, you cannot triumph against Death; that is a given. But how will you face your inevitable defeat? What will you make of it?

What legacy will you leave behind?

“By my troth, I care not; a man can die but once; we owe God a death. I'll ne’er bear a base mind: an’t be my destiny, so; an’t be not, so. No man’s too good to serve’s prince; and let it go which way it will, he that dies this year is quit for the next.”

— William Shakespeare, The Second Part of King Henry the Fourth